The coronavirus (COVID-19) has resulted in significant public market losses, as reflected in daily stock market gyrations and volatility. Private companies and asset values have equally been affected by the pandemic as investor appetite for riskier, illiquid investments is materially impacted in these conditions. This article series discusses strategies for companies, High Net Worth families and individuals that can provide a silver lining amidst the tough news and provide long-term benefits when valuations rise again. You can also download the whole article as a pdf.
Smart Strategies for Companies:
- Reprice Underwater Options or Units
- Make Equity Grants / Restructure & Rebalance
- Keep Track of Equity Transactions
- Execute Corporate Conversions
- Handle Spin-offs/Carve-outs
Reprice Underwater Options & Units – Reset Your Option Valuation
- Typically, companies will commission a valuation annually, or in conjunction with funding rounds, to set the strike price of options, profits interests, phantom stock and other equity incentive units
- This is commonly referred to as a 409A valuation in the US and an EMI valuation in the UK (submitted to HMRC)
- This ensures companies and their employees are in compliance with tax requirements and don’t face problems later on in the event of review by later round investors, auditors or tax regulators
- Many units may now be “underwater” (the strike price is above the stock price) killing their incentive and retention value
- New hires equally, will require a strike price for their options/units, and using a pre-COVID-19 valuation may vastly overstate that strike price
What to Do Now?
- With a new valuation, you can execute a repricing or exchange of previously issued options; often valuations can be 20-40% lower
- The strategy we see most commonly and easily executed is where companies cancel prior options and reissue new ones at the lower strike price, but hold vesting conditions the same; this is typically comparatively quick and inexpensive to executive, with immediate and clear benefits
- Other strategies can include swapping options for other incentive units (e.g. options for restricted stock awards or RSUs), repricing existing options directly, or cash buyouts — all of these options need close review to understand their interplay with plan documents and applicable laws
- Current Staff: Otherwise stuck with underwater options & at a higher strike price than new staff
- New/Future Staff: with units that will motivate them;
- Company – re-establishing the intended incentive & retention functions of their equity awards
Make Equity Grants – Restructure Ownership
- Similar to the repricing options, this can be a good moment to make a grant of equity and/or profits interests in your company; many owners/founders have key principals they want to bring into the business, or employees that have been with them for some time, and for whom they want to give a direct ownership stake
- Equally, this may be a time to rebalance or restructure ownership arrangements between existing co-owners / founders — sometimes this can be family members in a family-owned business
- The challenge in many of these rebalancing exercises is often that value of the shares is high, and a tax liability is triggered; Direct grants of stock or capital interests have immediate tax consequences
- Equally, when valuations are high, it may limit or prove an obstacle to the desired and most optimal restructuring
- Any person receiving new equity in a business must either pay income tax on those shares or otherwise declare a taxable gain, depending on the structure
- The hurdle rate for profits interests is based on the value of the company at the time the units are granted
What to Do Now?
- If your goal is to maximize the incentive / motivation of the grant, and/or to minimize tax liability for the recipient, the new lower valuation environment can provide a good moment to get these issuances done and out the door; equally restructuring/rebalancing transactions can be optimized for all parties
- Recipients: will benefit from the reduced tax hit in the immediate moment and from long-term value gains if the shares appreciate in the future
- Company: Benefits from a smoother negotiation and may have flexibility to offer greater units in the moment at the lower valuation
Keep track of Equity & Option Transactions
The current market challenges have led to reductions in staff and changes in processes and procedures with teams working from home. In this context, it’s very important that equity records are kept up to date. This can include:
- Records of vested and unvested equity awards at the time of employment separation, which are important for understanding the employee’s rights and options
- Equally, it’s important to be clear on rules in plan documents and equity awards related to when a recipient changes employment status (furlough, leave of absence, full-time/part-time transition, voluntary or involuntary termination)
- New Grants, strike prices, hurdle rates, termination provisions and other key aspects of grants need to be effectively captured
- All equity information should be current, accurate and completely accessible remotely
We’ve launched a key software tool and concierge service CapGuru that can help make sure you are always able to handle these events with confidence; we do the heavy lifting for you and you don’t need to hefty external advisory fees to get it done right.
Execute Corporate Conversions
- The 2017 Tax Cuts & Jobs Act (TCJA) raised the debate as to whether to operate in corporate or LLC/S-corp form by changing tax provisions
- Corporate earnings are taxed twice (at corporate level and then again at shareholder level); LLC/S-corp earnings are taxed once
- There may be advantages to converting from a C-corporation to either an LLC or S-corporation now to take advantage of TCJA changes
- Conversely, converting from an S-corp/LLC to a C-corporation may be advantageous where it affords access to s.1202 benefits (Qualified Small Business), enabling tax-free gains on a sale of the company where exit plans make it worthwhile
- Moving from a C-corporation to LLC form is considered a deemed tax liquidation event: the corporation is taxed on any appreciation built-into its assets (“BIG” – built-in gain) and its shareholders are taxed on the deemed liquidation distribution
- Moving from a C-corporation to an S-corp also triggers tax on corporate asset built-in gain; the gain is taxed at the corporate level if the asset is disposed of within 5 years
- For s.1202, it’s required that the gross assets of the company at the time fall below a certain valuation threshold in order to for the shares to qualify
What to Do Now?
- When valuations are reduced, both the corporate gain (if any) generated on the deemed liquidation and shareholder tax (if any) that arises on any assets deemed distributed will be minimized; thus you can execute the conversion and pay materially reduced taxes
- For s.1202, a good time to make this move is when asset values are depressed in order to more easily qualify under the valuation threshold
- Company & Shareholders with improved tax positions and the ability to reap significant gains in the future
Handle Spin-offs – Carve-outs
- Spin-outs of business units & assets from an existing company can be an key strategic move to unleash the value of the captive unit/assets
- A corporate parent can dispose of a subsidiary or technology; many private companies start with a services model but incubate a technology, they ultimately spin that technology out of the business – this allows new investment to happen for the spin-out, and for staff to be given share/option incentive compensation for the spin-out alone
- Keeping the value of the spun-out entity or assets as low as possible is often critical to both the parent company and to NewCo to optimize the transaction
- This can also be highly relevant where a company is seeking preferential s.1202 treatment for NewCo (as noted above)
- Many spin-outs cannot be executed under the tax-free spin-off provisions of the relevant jurisdiction, thus driving two levels of taxation: corporate gain on the distribution, as well as tax on the distribution to stockholders
- Distributing the stock of a subsidiary/NewCo when value is low will reduce the tax exposure in all cases
What to Do Now?
- Take your business unit/subsidiary/“incubated” business line or technology and effect a spin-out; get the entity or assets valued
- Make sure you select an optimal effective date for the valuation
- If circumstances warrant, a Fairness Opinion may be needed to ensure the Board can effectively discharge its fiduciary duties to all shareholders
- Company, shareholders of Parent / OldCo. shareholders of NewCo, and ultimately employees of NewCo
Overall, this may be an opportune moment to either reset a prior valuation or to get a new valuation commissioned. In many cases, it may be prudent to consider/review whether the value calibrates in another 6-8 months as things settle down and greater visibility reveals itself as to COVID-19 impact and forward-looking performance. But whatever you do, make sure your actions are well documented and defensible in light of financial and valuation principles.
The one lesson of any downturn is that, when the dust clears, all of these actions are reviewed in a different world and often subject to fierce challenge. If you are a company that is angling towards an exit or an IPO, rest assured that buyers’ diligence teams, the SEC and the IRS review stock awards closely.Download the full article
How can we help?
If you are a current Oxford client, we recommend that you reach out to discuss whether you or your company can benefit from any of these strategies. If you are not currently a client, we are more than happy to discuss this with you and help you in thinking through the best path forward. To learn more contact OVP or email us at firstname.lastname@example.org to set up time to talk.
Oxford Valuation Partners