Rev Proc 2007 44 for Private Company Stock Valuation

Revenue Procedure 2007-44 provides guidance from the Internal Revenue Service (IRS) for private companies. Its purpose is to offer a “safe harbor” for the valuation of private company stock, specifically in the context of nonqualified deferred compensation plans. This guidance is directly linked to Internal Revenue Code (IRC) Section 409A, a set of rules governing deferred compensation. When a private company issues stock options or other equity-based awards, it must determine the fair market value of its stock to set the exercise price.

Complying with Section 409A is important, as failure to do so can result in severe tax consequences. While the most significant tax penalties are imposed on the employee, the company is not without responsibility. For the employee, these penalties can include immediate income taxation on all deferred compensation, an additional 20% tax, and interest charges. The company has a mandatory obligation to report this income and withhold the appropriate taxes, and failure to meet these duties can expose the company to its own penalties.

Determining Eligibility for the Safe Harbor

The safe harbor valuation methods are available to a “service recipient,” which is the company or entity for which services are being performed. The central condition for eligibility is that the service recipient’s stock must not be “readily tradable on an established securities market.” This limits the use of this guidance to private companies, including startups and other closely held businesses whose shares are not bought and sold on public exchanges.

This guidance is intended for valuations related to stock rights, such as stock options and stock appreciation rights (SARs), that fall under the purview of Section 409A. The valuation is necessary to establish the fair market value of the underlying stock on the date the right is granted.

By using one of the prescribed valuation methods, a private company can establish a stock price that the IRS will presume is reasonable. This presumption can only be rebutted if the IRS can demonstrate that the valuation was “grossly unreasonable.” For a private company granting equity, confirming it is not publicly traded and that the equity awards are subject to Section 409A are the foundational steps to determining if it can benefit from this revenue procedure.

Permissible Valuation Approaches

Revenue Procedure 2007-44 outlines three distinct approaches that, if properly applied, create a presumption of reasonableness for the valuation of private company stock. The choice of method depends on the company’s stage of development, its available resources, and the nature of its business. Each approach has specific criteria that must be met to qualify for the safe harbor protection.

The Independent Appraisal Presumption

To meet the safe harbor requirements, a company can obtain a written appraisal from a qualified and independent appraiser. The appraisal must be conducted by an individual or firm with significant knowledge, experience, and skill in performing such valuations. The experience criteria means the appraiser has a recognized certification or has extensive, demonstrable experience in valuing similar private companies.

The independence of the appraiser is a main factor. The appraiser cannot be a current or recent employee, officer, or director of the company. They also cannot be a major shareholder or have a material business relationship with the company that could compromise their objectivity. The final written report from the appraiser must detail the methodologies used and the factors considered in reaching the valuation conclusion.

The Illiquid Start-up Presumption

The “illiquid start-up” presumption is a valuation method for certain early-stage companies. To qualify, the company must have been in business for less than 10 years and must not reasonably anticipate a change of control event within 90 days or an initial public offering (IPO) within 180 days of the valuation date.

The valuation itself must be performed by a person with significant knowledge and experience, though this individual does not need to be a third-party appraiser. This could be a qualified employee or board member, provided their expertise is properly documented. The valuation must be evidenced by a written report that considers relevant factors like assets, cash flows, and the market value of comparable companies.

The Formula-Based Valuation Presumption

A company may use a formula to determine its stock’s value. This approach is permissible if the formula is used for all valuations of the company’s stock, including for compensatory and non-compensatory purposes. For instance, if the company uses a specific formula to value stock for buy-sell agreements with founders, it can use the same formula to set the exercise price for employee stock options.

The formula must be based on principles of fair market value, often incorporating metrics like a multiple of earnings, book value, or a combination of financial indicators appropriate for the company’s industry. The formula must be applied consistently in all transactions involving the company’s stock, representing a genuine agreement among parties about how the shares should be valued.

Documentation and Reporting Requirements

To rely on any of the safe harbor valuation methods, a company must maintain thorough documentation in a comprehensive written report. This report substantiates the fair market value conclusion and serves as evidence that the valuation was conducted in accordance with the standards in Revenue Procedure 2007-44.

The written report must contain several elements:

• The effective date of the valuation and the specific valuation method being used, whether it is the independent appraisal, the illiquid start-up presumption, or a formula-based approach.
• A detailed discussion of the factors considered during the valuation process, including an analysis of the company’s financial statements, assets and liabilities, business prospects, and the value of its tangible and intangible assets.
• The qualifications of the individual or firm that performed the valuation. If an independent appraiser was used, their credentials, experience, and a statement of their independence should be included.
• If the valuation was performed internally under the illiquid start-up presumption, the report must describe the knowledge and experience of the person responsible.

Timing and Validity of the Valuation

A valuation performed under the safe harbor provisions is considered reasonable and can be relied upon for up to 12 months from its effective date. This means a company can use a single valuation report to set the exercise price for all stock options granted within that 12-month window, provided no significant events occur that would materially affect the company’s value.

The valuation will be rendered invalid before the 12-month period ends if the company undergoes a material event that would reasonably be expected to change the value of its stock. Such triggering events include a new round of financing where shares are sold to outside investors at a different price or a definitive agreement for a merger or acquisition.

Other events can also render a valuation obsolete. A significant change in the company’s financial condition, such as a major new contract or the loss of a key customer, could materially impact its value. The onset of a regulatory or legal challenge that threatens the business model might also necessitate a new valuation.