New Accounting and Deferred Compensation Rules Impact Compensation Strategies –

The end of 2004 brought new accounting rules for equity compensation and new deferred compensation legislation that will greatly impact how executive compensation arrangements are structured. This article discusses how these new rules are likely to impact executive compensation strategies in venture-backed private companies.

Option Expensing is Coming. On December 16, 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised) (“FAS 123(R)”). FAS 123(R) will generally require private companies to expense stock options and other equity-based compensation arrangements starting in 2006. The application of FAS 123(R) will be prospective for private companies, and will apply only to newly granted awards and existing awards that are modified, repurchased or cancelled after the effective date.

Fair Value or Intrinsic Value. Once a private company is subject to FAS 123(R), it will need to expense options and other equity awards using either an intrinsic value or a fair value approach. If a private company continues to use an intrinsic value approach (i.e., the “spread”), then it will be subject to variable accounting treatment and will need to remeasure the “spread” on a quarterly basis until the award is settled. Although generally many private companies do not mind variable accounting treatment, it may be problematic for a private company that intends to undergo an initial public offering and may cause problems under certain financial covenants in loan agreements.

It is expected that most private companies will choose to use the fair value approach, which will generally fix the value at the time of grant. The fair value approach will require that equity awards be valued using either a closed-form option pricing model (e.g., the Black-Scholes-Merton formula) or a lattice model (e.g., a binomial formula). Since the fair value approach generates much higher values than the intrinsic value approach, it is expected that compensation expense will increase once FAS 123(R) is applicable, especially for companies that grant a significant amount of options.

Actions to Take This Year. Since FAS 123(R) applies prospectively only to equity awards that are granted, modified, repurchased or cancelled after it becomes effective, it is expected that many private companies will grant additional equity awards this year. For instance, if a private company with a calendar fiscal year typically makes option grants each February, it will reduce the accounting expense if grants that would ordinarily be made in February 2006 are made sometime in late 2005, so that such awards will not be subject to FAS 123(R).

In addition, if a private company is considering making modifications to its existing equity awards (e.g., to change the post-termination exercise period), it may be beneficial to make those modifications before FAS 123(R) becomes effective. Under APB 25, a modification generally requires a new measurement date (i.e., remeasure the “spread” at the date of modification. Under FAS 123(R), however, the modification will require measuring the fair value of the equity award at the date of modification).

Repricing Rules Changing. Once FAS 123(R) is effective, private companies will not be subject to variable accounting treatment when they “reprice” options, and will no longer have to wait “six months and one day” to regrant options. When a company reprices options under FAS 123(R), it will have to take an expense equal to the increase in the options’ value, but such expense will be fixed at the time of repricing.

Performance Vesting. Unlike the current accounting rules, FAS 123(R) will not require variable accounting treatment for stock-settled awards that have performance vesting. Since equity awards with performance vesting will be treated the same as equity awards with time vesting, private companies that want to use performance vesting will no longer need to include a fixed vesting date (e.g., the seventh anniversary of the grant date). Private companies may also use an IPO as a vesting criteria.

Changing Option Terms. Since the fair value approach considers factors such as the expected life of the equity award, it is expected that many companies will shorten the terms of options. For instance, an option with a five-year term will generally have a lower fair value than an option with a 10-year term. In addition, since companies may generally take into account the tax benefits (e.g., the value of any tax deduction) associated with an equity award, there is additional benefit to the company to award non-qualified options rather than incentive options (since there is no tax deduction for incentive options that are held for the required amount of time).

Restricted Stock More Favorable. Finally, under FAS 123(R) the compensation expense for restricted stock awards will generally be the value of the award at the date of grant (i.e., the value of the stock less any purchase price paid). As a result, the compensation expense for restricted stock awards will be less than the compensation expense for options. Consequently, it is expected that many private companies will increase the use of restricted stock awards (and restricted stock units) and will decrease the use of options.

New Deferred Compensation Rules. On October 22, 2004, the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code of 1986. Section 409A imposes broad new restrictions on deferred compensation arrangements. The new deferred compensation rules not only apply to garden-variety non-qualified deferred compensation arrangements, but also to stock appreciation rights, discounted options, phantom stock, restricted stock units, supplemental retirement arrangements and other promises to pay compensation in the future, including certain guaranteed severance payments. Arrangements between a partnership (including an LLC taxed as a partnership) and a partner may also be subject to Section 409A. Many existing arrangements that were vested before January 1, 2005 will not be subject to the new rules, provided they are not materially modified after October 3, 2004.

Penalties for Non-Compliance. Like FAS 123(R), the new deferred compensation rules under Section 409A will have a broad impact on compensation strategies for private, venture-backed companies. If a deferred compensation arrangement does not comply with Section 409A either in form or in operation, then the amount deferred will generally be taxable to the executive in the year when it was initially deferred, which may be a prior year. In addition, the executive will be subject to an additional 20% tax, as well as interest if the initial deferral was in a prior year.

Restrictions on Timing of Payment. Section 409A requires that deferred compensation may only be paid upon the occurrence of certain permissible triggers, including termination of employment, a fixed date or a change in control of a corporation. The payment of deferred compensation may not be triggered by a change in control of a partnership (including an LLC that is taxed as a partnership) or upon the occurrence of other events, such as an IPO, the completion of a round of financing or the financial instability of the company. In addition, a company may not accelerate the payment of deferred compensation in its discretion, and delaying a payment date is greatly restricted.

The inability to pay deferred compensation upon the occurrence of an IPO or a change in control of a partnership is problematic for many private companies. Companies that are taxed as a partnership will need to determine what arrangements are triggered on a change in control and may need to modify such arrangements. One approach is to tie vesting to one of these impermissible triggers, then trigger payment off a permissible event, such as a subsequent termination of employment.

SARs Out, Restricted Stock In. Section 409A effectively eliminates the ability to grant stock appreciation rights, and any stock appreciation rights granted after October 3, 2004 should be reexamined. Restricted stock awards, on the other hand, are generally not subject to Section 409A, which when considered with the favorable accounting treatment and income tax treatment to the executives, is likely to result in more frequent use of restricted stock over options.

Added Scrutiny of Option Exercise Prices. Section 409A will put more pressure on private companies to determine the fair market value of their stock when granting options. In this regard, any reasonable valuation method may be used. If the company underestimates the fair market value of its stock, then it may unintentionally expose its employees to detrimental tax consequences, including the additional 20% tax. In addition, executives of venture-backed private companies may try to negotiate for gross-up protection from such detrimental tax consequences.

Need to Modify Existing SARs and Discounted Options. For all existing options and stock appreciation rights with an exercise price that is below the fair market value of the stock at the date of grant, they will need to be modified or cancelled before the end of 2005. One way to fix such awards is to increase the exercise price to equal the fair market value of the stock on the date of grant. Although not addressed by the guidance under Section 409A, it is expected that companies will try to otherwise compensate employees for any lost value in bringing such awards into compliance with Section 409A.

Conclusion. The new accounting and deferred compensation rules will require all venture-backed private companies to reexamine their current compensation arrangements and reexamine their approach for new compensation arrangements. Most importantly, private companies, and the venture firms that finance them, will need to focus more attention on the details of how their employees and executives are compensated in order to avoid detrimental accounting and tax consequences in the future.

For further information, please contact Scott A. Webster, Partner, Goodwin Procter LLP. Email:

swebster@goodwinprocter.com or Tel: 617.570.8229.