Certified Valuation Analysts

Click here to view Part 1 of our series and learn more about the stock option landscape or Part 2 to learn more about the accounting and tax ramifications of issuing stock options.

What To Do?

As discussed above, there are significant risks that a company brings upon itself if it decides to issue stock options without properly valuing the options and the equity of the company. Rather than issuing stock options, if a company wants to offer an employee the opportunity to obtain an ownership interest, the most efficient and “clean” method may be to allow the employee to purchase shares from the company or from existing owners. There is no valuation requirement in this case (unless a party wants to hire an expert to ensure that they the transaction price is fair and reasonable) which also eliminates the out-of-pocket cost for the employer. In fact, a business actually recognizes a cash inflow when an employee purchases shares directly from the company. 

I am a valuation expert and I directly benefit from work associated with the valuation of stock options, so why am I telling you to consider alternative routes of compensation? Too often, the companies that issue stock options without having them professionally valued are the same companies that will fight against having their options valued at all due to the cost associated with the valuation. I simply want to spread awareness that there are other avenues of compensating employees and giving them opportunities for equity ownership that may be more cost efficient for companies that are under the illusion that issuing stock options does not require a cash outlay.

If you take anything away from this article, remember that issuing stock options is not a “cashless” expense. Consider that there are other alternatives for compensating employees other than using stock options. Remember that there are transaction costs associated with issuing stock options, specifically, hiring a valuation expert, that will create real out-of-pocket cost for any company. Unless you are ready to comply with the valuation requirements associated with issuing stock options, you may be better off simply not using them and compensating employees in another manner. Finally, just like selling a home, if you are going to issue stock options make sure that you bring in an expert to ensure that the value of the company and options are determined and documented appropriately – and be prepared to pay the “commission” for these services.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.

Accounting and Tax Ramifications of Issuing Stock Options

 Click here to view Part 1 of our series and learn more about the stock option landscape.

To give you more perspective, first let us review the accounting treatment for the issuance of stock options (rest easy - this will not be too painful). When stock options are issued, an expense must be recorded based on the value of the option. A stock option’s value is derived from a variety of factors, two of which are the value of the stock as of the date of the option grant and the exercise price of the option (the price at which the option holder can purchase a share of stock). Determining the value of a company’s stock is not difficult when it is publicly traded, but privately-held companies do not have readily available market prices, which necessitates the services of a valuation expert. Unless the option is properly valued, a company cannot correctly record the associated compensation expense. If a company is unable to correctly record the results of its operations, it may find obtaining a clean audit opinion to be a difficult, if not impossible, task.

Now that I have warned you about the headaches that you may encounter on the “accounting” side of issuing stock options, let me further alarm you with the tax ramifications. If a company sets the stock option exercise price lower than the fair market value of its stock on the grant date, the stock option could be deemed to be deferred compensation according to Internal Revenue Code 409A. Under 409A, such deferred compensation would be immediately taxable to the employees receiving the grant and subject to regular income tax rates plus 1%. Perhaps even more distressing, a 20% penalty plus interest would also be triggered. In addition, employers would be responsible for withholding income taxes for employees on these types of option grants, which if not done, could result in additional tax penalties. The immediate taxability, penalty and withholding requirements do not apply when the stock option exercise price is equal to or greater than the fair market value of the company’s stock on the grant date. It is impossible to compare the exercise price of a stock option to the fair market value of a company’s stock unless a valuation of the company’s stock has been performed. In addition, when a valuation has been performed to establish the fair market value of a company’s stock, the burden of proof shifts to the IRS to disprove the appraised value. Therefore, unless there is documentation to support the fair market value of a company’s stock near the option grant date, there could be significant tax issues in addition to the accounting issues alluded to earlier.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit us tomorrow for Part 3: What to Do?

In the meantime, visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.
 

When selling your home, it is common to use an agent to list, promote and show the property. In exchange, you pay a portion of the sales price as a commission to the agent. The benefits of using an agent include: 1) the listing of your home in a database so that homebuyers can access information about it; 2) the agent acting as your middleman during the negotiation process; and 3) the incentive it gives the agent to sell your home quickly (so that her or she can earn their commission). 

Some people choose to sell their home by owner and forego using an agent. These are typically the homes that have “For Sale” signs in their yards for many months, sometimes even years (you know the ones), before they are actually sold. These people often believe that the benefit of not having to pay an agent commission on the sale of their home is worth the prolonged period it will likely take to sell the property. 

What does the choice of hiring a real estate agent or selling your home by owner have in common with private companies issuing stock options? The strange answer is: Much more than many of us realize. 

The Stock Option Landscape

More and more private companies are issuing stock options as part of their key employees’ compensation plans. This may be driven by the ideas that: 1) stock options don’t “cost” anything to the company; 2) stock options will positively influence employees’ performance; or 3) since public companies issue stock options, it must be a good idea and private companies should follow suit. Regardless of the motivation, what most private company owners and executives do not realize is that accounting for stock options, for both tax and financial reporting purposes, may actually have an out-of pocket cost that is greater than the value of the options themselves.

In order to value stock options issued by private companies, there are two major steps that must be undertaken:

1. Determining the value of the company’s equity (which is a key input to valuing a stock option)

2. Determining the value of the stock option

There are not many privately-held companies with the in-house resources or expertise necessary to perform either of the requirements above, both of which are essential in accounting for the issuance of stock options. This often puts accountants in the awkward position of trying to explain to business owners the “unseen” costs and accounting ramifications associated with issuing stock options.

Back to our analogy, hiring a valuation expert to determine the value of stock options is much like hiring a real estate agent to sell your home. A valuation expert is able to perform both of the tasks identified above that are necessary to value the stock options issued by a private company, much like a real estate agent takes care of the necessary steps to sell your home. This work is not free, however, and depending on the complexity of the company and the options issued, the cost to value a private company’s stock options can range in cost from thousands to tens of thousands of dollars. When private companies issue stock options, they often do not consider the “commission” that they will have to pay to a valuation expert to ensure that the options are properly valued. Unlike real estate agent commissions, however, which are based on the sale price of the home, valuation fees are relatively fixed. 

Just like selling a home “by owner,” some companies will issue stock options and try to determine the value themselves (or even worse, not value them at all). By not using a real estate agent, homeowners often find themselves making no headway in the sale of their home. Similarly, by not hiring a valuation expert to value the stock options that they have issued, private companies create the risk that their auditors will not sign off on their financial statements. Maybe even more importantly for business owners and employees, unsubstantiated option values leave both companies and their employees in danger of stiff tax consequences.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit us tomorrow for Part 2: The Accounting and Tax Ramification of Issuing Stock Options

In the meantime, visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.

We, as consumers, love discounts. There are few things more satisfying for a savvy shopper than finding a deal on an item that he or she has been longing for. When it comes to valuing a business, some believe that “discount” is a dirty word and that it implies that the seller is not receiving fair market value for his ownership interest and that the buyer is getting a deal. This is not the case, however, as valuation discounts merely adjust the value of an ownership interest indicated by certain valuation methods for specific characteristics that need to be addressed before arriving at fair market value. 

The most common discounts seen in valuation reports are for lack of control and lack of marketability. 

Lack of Control Discounts

Lack of control discounts are appropriate for ownership interests in which the owner cannot unilaterally direct the company’s operation. A lack of control discount is applied because a non-controlling owner cannot appoint management, set levels of management compensation, declare dividends or distributions, compel a liquidation of his or her ownership interest, set company policies, or purchase or sell assets, just to name a few things. These factors make a non-controlling interest less valuable than a controlling interest.

Marketability Discounts

Marketability discounts are also often appropriate in the valuation of privately-held businesses.  There are certain marketability differences between an interest in a privately-held business and an interest in the stock of a publicly-traded company. An owner of publicly-traded securities can know at all times the market value of his or her holding based on the quoted price per share. He or she can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days.

This is not the case with ownership interests in privately-held companies, however. Liquidating or selling a position in a privately-held company is a more costly, uncertain, and time-consuming process than selling the stock of a publicly-traded company. An investment in which the owner can achieve liquidity in a timely fashion is worth more than an investment in which the owner cannot liquidate the investment quickly. Therefore, an ownership interest in a privately-held company with the exact same characteristics as a publicly-traded company would sell at a discount compared to the publicly-traded company.

What Does It All Mean?

Valuation discounts are not a simple matter, but they are an essential part of determining the fair market value of ownership interests in privately-held companies. The subjectivity in determining valuation discounts is often a source of contention in valuations for divorce, shareholder disputes, and estate and gift tax filings. Therefore, it is essential that your business valuation analyst have a well-reasoned and thorough discount analysis in order to stand up to challenge or scrutiny. 

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Topics: Cleveland Business Valuation, Akron Business Valuation, Certified Valuation Analyst

A business valuation is a just a business valuation – isn’t it? This would be akin to saying that a steak is just a steak when, in fact, there are ribeyes, strips, sirloins, and filets (just to name a few). Likewise, business valuations come in two distinct “flavors” – conclusions of value and calculations of value.

As of January 1, 2008, valuation analysts who hold either the Certified Valuation Analyst (CVA) credential supported by the National Association of Certified Valuation Analysts or the Accredited in Business Valuation (ABV) credential supported by the American Institute of Certified Public Accountants have been required to follow new standards that clearly delineate between two types of valuation engagements. Similar to the differing levels of service traditionally offered by accounting firms in performing audits, reviews, or compilations, business valuation engagements are now separated into two defined service categories:

Conclusion of Value

-          All three valuation methods (asset-based, income-based, and market-based) are required to be considered

-          Detailed development and reporting requirements must be adhered to by the valuation analyst, making the engagement more time consuming than a calculation of value

-          This is the required type of report for estate and gift tax filings; Also typically required for instances in which the valuation analyst will need to defend his or her findings and report (i.e. in litigation)

-          The valuation analyst opines on the value of the business or business ownership interest

Calculation of Value

-          The valuation methods to be used in determining value are discussed and agreed upon beforehand between the client and the valuation analyst

-          Reduced development and reporting requirements compared to conclusion of value engagement

-          Ideal for planning purposes (e.g. strategic planning, transaction (purchase or sale) planning, or litigation or divorce proceedings in the settlement stage)

-          Valuation analyst does not opine of the value of the business or business interest, rather, the valuation analyst applies the valuation methodologies agreed upon with the client

-          Generally not defensible in litigation settings because the valuation analyst is not offering an opinion of value, rather, the analyst “calculates” a value based on methods agreed upon with the client

-          Typically costs less than a conclusion of value

-          Has been found to be useful in divorce situations in which a spouse will obtain a calculation of value to aid in the settlement process; If a settlement is not reached, the engagement can then escalate to a conclusion of value so that the valuation analyst can opine on a value and defend it in court, if needed

As you can tell from the discussion above, all “valuation” work is not created equal. For business owners, as well as their attorneys and other advisors, it is important to be aware of the varying levels of valuation service offered so that the appropriate type of report is obtained. You should discuss the purpose of the valuation with the valuation expert in detail as the engagement is forming so that the level of service can be tailored to your specific needs. 

The last thing that you want to do when having a valuation performed is pay too much to obtain a conclusion of value that will only be used for planning purposes or pay too little to obtain calculation of value that will not hold up in litigation or under IRS scrutiny.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

Topics: Cleveland Business Valuation, Akron Business Valuation

Selling a business can be one of the most challenging tasks that business owners face. Click here to read “Avoiding Seller’s Remorse,” featuring our own Robert A. Ranallo, CPA/ABV, JD, CVA, CFF.

Need assistance valuing your business? You can contact our team of Certified Valuation Analysts at 440-449-6800.

Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.