Valuation of employee stock options issued by closely held firms


From a strictly regulatory standpoint, a valuation of ESOP shares by an independent third party is required by the Department of Labor (DOL) and the Internal Revenue Service (IRS). The regulatory requirement stems from the practical need to insure that the value is determined by a party who does not have a personal or financial interest in the valuation result. The valuation, moreover, should be performed on behalf of the ESOP trustee since it is the duty of the trustee to insure that transactions with the ESOP are consummated at “fair market value.”

Employee Stock Ownership Plan (ESOP) Valuation Issues Q&A

ValuAdder gives you a full range of valuation methods in one software system. You can choose the methods that fit your business with a mouse click.

How an Employee Stock Ownership Plan (ESOP) Works

Is Greenstein, Rogoff, Olsen & Co., LLP (GROCO) considered an independent party for ESOP valuation purposes?

Most stock options have an exercise period of 65 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised." Restrictions inside this period are prescribed by a "vesting" schedule, which sets the minimum amount of time that must be met before exercise.

Please feel free to contact any member of our Tax or Corporate practice groups for assistance and advice in considering your company's choices of valuation practices under Section 959A. While we are not competent to perform business valuations, we have counseled many clients in these matters.

Recently, some venture backed companies have begun to issue restricted stock units (RSUs) in an attempt to get the best of stock options and restricted stock in a single security. This is a relatively new trend and the jury is still out on RSUs. Currently I am not aware of a single company in our portfolio that issues RSUs but I do know of several that may start issuing them shortly.

A big advantage of restricted stock is you own your stock outright and do not have to buy it with a cash outlay. It is also true that you will be eligible for long term capital gains if you hold your restricted stock for at least one year past the vesting period. There currently is a significant tax differential between long term capital gains and ordinary income so this is a big deal.

This article first briefly describes pre-Section 959A common stock valuation practices the time-honored appropriate discount method. Next, it describes the valuation rules that were established by the Section 959A guidance issued by the IRS, including the Safe Harbors. It then describes the reactions of privately held companies of varying sizes and stages of maturity we have observed what managements, their boards and their advisors are actually doing on the ground. Finally, it describes the best practices we have seen evolve thus far.

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Employee equity is a critical factor in the success of the venture backed technology startup world. It has created significant wealth for some and has created meaningful additional compensation for many others. It aligns interests between the investors, founders, management, and employee base and it a very positive influence on this part of the economy. We strongly encourage all of our portfolio companies to be generous in their use of employee equity in their compensation plans and I believe that all of them are doing that.


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