Private M & A - Seller's Misrepresentation, Non-Reliance Clause and Remedy

• Non-Reliance Clause: Provision included in an acquisition agreement for the benefit of the seller, in which the buyer confirms that, except for the express representations contained in the "representations" section of the acquisition agreement, the buyer has not relied on any representations or other statements made on behalf of the target company or the seller or any of their representatives. But what about adding a "fraud exception" clause thereto? Is it logical? It seems fundamentally contrary to the very bargain struck among the parties---that the buyer agreed that it is not relying on any representations outside the four corners of the agreement. But in a hot auction deal, where the pressure to get the bid accepted by the seller is enormous and only a set of skinny reps are included in the form agreement, this exception might be the only effective way to protect the potential buyer. See also in FDG Logistics v. A&R Logistics, where a Delaware court held that a "no other representations" representation was not an effective disclaimer (to function as a non-reliance disclaimer). 
• Breach of Contract Claim:  Claim under the express indemnification provisions of the acquisition agreement for breaches of the contractual representations made by the seller in that acquisition agreement, which will be subject to all of the caps, deductibles, mini-baskets, survival limitations and other contractual limitations on indemnification that were negotiated by the seller in the acquisition agreement.
• Tort Claims for Fraud for Deliberate Misrepresentation: Presumably not subject to the contractual indemnification provisions; but see limitation of liability clause of the acquisition agreement. 

                1. The buyer may claim that the seller knew that certain of these representations were wrong and that the buyer, therefore, has the right to recover from the seller in tort for his having defrauded the buyer. The presence and absence of non-reliance clause is not relevant.

                2. The buyer may assert that certain statements made to it or certain documents delivered to it during the due diligence investigation of the target company's business were fraudulent, even though those statements and documents were not specifically covered by any of the seller's express representations in the acquisition agreement (e.g., financial projections slide deck provided but not covered by the acquisition agreement reps and warranties). The presence or absence of non-reliance clause is material for the buyer in seeking its remedy at least in Delaware and those states that follow Delaware's approach---the buyer's claim for fraud outside the contract will be dismissed because of the presence of the non-reliance clause because Delaware courts take the position that if the buyer brings a claim for fraud outside the contract after specifically representing that it relied only on the representations expressly included in the acquisition agreement, then the buyer's non-reliance representation was in fact a misrepresentation, and that should preclude the buyer from recovering on its fraud claim. A good non-reliance clause can actually protect the seller against successful tort claims for fraud outside the contract. 

Best Efforts? Commercially Reasonable Efforts?

Words of caution if you ever use "efforts" clauses instead of unambiguous obligations.

Consider using such clause is the market/industry practice

Use the same terms consistently throughout the agreement

Consider dispute identification mechanism at a sign of dispute or disagreement as to performance

Include temporal limitations and certainty

Consider time frames for efforts including within specific number of days or months from a triggering date or event

Define efforts

Sample definitions in the context of M & A:

• "Efforts that a prudent Person desirous of achieving a result would use in similar circumstances to ensure that such result is achieved as expeditiously as possible on commercially reasonable terms."
• "Efforts that a prudent Person desirous of achieving a result would use in similar circumstances to achieve such result as expeditiously as possible; provided, however, that a Person required to use commercially reasonable efforts under this Agreement will not be required to take actions that would result in a material adverse change in the benefits to such Person of this Agreement and the transactions contemplated hereby or to dispose of or make any change to its business, expend any material funds or incur any other material burden."
• "Efforts consistent with the past practices of similarly situated [INDUSTRY] companies with respect to similarly situated [MATTER]"
• "Efforts consistent with the past practice of [PURCHASER] related to research and development, regulatory approval, commercialization and sales and marketing of similar [PRODUCTS] with similar market potential at a similar stage in development"

Include carve-outs as what efforts clause does not require of covenanting party

• Expense cap in dollar amounts on attorneys' fees and other costs
• Conduct that would reasonably be expected to have a material adverse effect on covenanting party
• Actions that would subject the covenanting party to liabilities
• Actions in contravention of law or regulatory requirements
• Actions that would impact profitability or solvency of the covenanting party
• Fiduciary outs (subject to break-up fee and other deal protections for the buyer)

HSR or other regulatory approvals

• Reverse break-up fee
• Ticking fees that increase based upon length of time it takes to address concerns
• Detailed efforts covenants identifying problematic lines of business or assets to be divested
• Negative covenants of buyer restricting pre-closing acquisition of assets or business or other actions that would exacerbate antitrust problems

Third Party Consents

• Control or specify the timing of pursuing consents, expenses in doing so, and thresholds for closing (must-have consents)
• Consider third party leverages 

Acquisition Financing

• "Buyer  shall, and shall cause its Affiliates to, use commercially reasonable efforts to obtain the Financing on the terms and conditions described in the Financing Letter, including using commercially reasonable efforts to (i) enter into definitive agreements with respect to the Financing (including agreeing to any requested changes to the Financing Letter by the committed lenders in accordance with the related flex provisions), (ii) satisfy (or obtain waiver) on a timely basis of all conditions in such definitive agreements (within buyer's control) and (iii) consummate the Financing contemplated by the Financing Letter at Closing."

NJ Escheat Law in the context of Reverse Triangular Merger

Hypothetical transaction: The target company, the Company, survived the merger and remains as a New Jersey corporation, wholly owned by the Parent, a DE corporation, post-merger. The merger sub created by the Parent for the merger, a New Jersey corporation, merged with and into the Company upon the closing. Assume for the purpose of the analysis, a large percentage of the previous shareholders of the Company were domiciled in New Jersey and a significant number of them have not provided documentation required for the payment of merger consideration.

New Jersey Escheat Law (Title 46, Subtitle 6, Chapter 30B. Unclaimed Property)

These New Jersey statutes provide a procedure by which personal property that is presumed abandoned is transferred to the State of New Jersey as custodian for the absent owner. Property is subject to the custody of the State of New Jersey as unclaimed property if one of the conditions raising a presumption of abandonment (Articles 2 and 5 through 16 of the statutes) exists and one of the other statutorily required conditions (under Section 46:30B-10) is satisfied.

The statutes have the following defined terms that are relevant to an escheat law analysis:

"Administrator" means the Treasurer of the State of New Jersey;
"Apparent owner" means the person whose name appears on the records of the holder as the person entitled to property held, issued, or owing by the holder;
"Domicile" means the state of incorporation of a corporation and the state of the principal place of business of an unincorporated person; and
"Holder" means a person, wherever organized or domiciled, who is the original obligor indebted to another on an obligation (The Company and Parent are deemed to be the holders of the merger consideration under the New Jersey statutes and that the Parent is a Delaware corporation does not prevent the State of New Jersey from reaching out to the Parent for the enforcement of these statutes).

1. Presumption of abandonment
“Stock or other interest in a business association” is presumed abandoned three (3) years after the date of an unpresented instrument issued to pay interest or a dividend or other cash distribution (Article 10; Section 46:30B-31). This section of the NJ statutes is what is considered as the most applicable to the circumstance in terms of the category of the underlying abandoned property. The definition of “business association”  under the statutes includes a corporation.

2. Other condition to be satisfied to subject the property to the custody of the state (basically establishing the nexus to the State of New Jersey):
• The last known address, as shown on the records of the holder, of the apparent owner is in New Jersey (I assume that this should be the case for those previous shareholders of the Company that are known to us as domiciled in New Jersey);
• The records of the holder do not reflect the identity of the person entitled to the property and it is established that the last known address of the person entitled to the property is in New Jersey;
• The records of the holder do not reflect the last known address of the apparent owner, and it is established that (1) the last known address of the person entitled to the property is in New Jersey, or (2) the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey and has not previously paid or delivered the property to the state of the last known address of the apparent owner or other person entitled to the property;
• The last known address, as shown on the records of the holder, of the apparent owner is in a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property and the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey;
• The last known address, as shown on the records of the holder, of the apparent owner is in a foreign nation and the holder is a domiciliary or a government or governmental subdivision or agency of New Jersey; or
• The transaction out of which the property arose occurred in New Jersey, and (1) the last known address of the apparent owner or other person entitled to the property is unknown, or (2) the last known address of the apparent owner or other person entitled to the property is in a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property, and (3) the holder is a domiciliary of a state that does not provide by law for the escheat or custodial taking of the property or its escheat or unclaimed property law is not applicable to the property.

3. Reporting obligations of holder
A person holding property presumed abandoned and subject to custody as unclaimed property under the statutes must report to the administrator concerning the property (Section 46:30B-46). Forms and other information related to the reporting is found http://www.unclaimedproperty.nj.gov/reporting-info.shtml.

4. Notice to apparent owner (Section 46:30B-49)
Not more than 120 days nor less than 60 days before filing the report required by the statutes, the holder in possession of property presumed abandoned and subject to custody as unclaimed property must send by certified mail, and with return receipt requested, written notice to the apparent owner at the last known address informing the owner that the holder is in possession of property if:

(a) the holder has in its records an address for the apparent owner which the holder's records do not disclose to be inaccurate;
(b) the claim of the apparent owner is not barred by the statute of limitations; and
(c) the property has a value of $50.00 or more.

5. Delivery of property
At the time of the filing of the report, the holder must pay or deliver to the administrator all of the unclaimed property set forth in the report and all accretions thereon unless the owner established the right to receive such property before the property has been delivered or the presumption of abandonment is erroneous (Section 46:30B-57-58).

6. Relief from liabilities  
Upon the payment or delivery of property to the administrator, the State of New Jersey assumes custody and responsibility for the safekeeping of the property. A person who pays or delivers property to the administrator in good faith is relieved of all liability to the extent of the value of the property paid or delivered for any claim then existing or which thereafter may arise or be made in respect to the property (Section 46:30B-61).

Delaware Escheats Law (Title 12, Chapter 11 of the Delaware Code)

The Delaware Code broadly mandates that all property, the title to which has failed and the power of alienation suspended by reason of (a) the death of the owner thereof intestate, leaving no known heir-at-law, (b) the owner having disappeared or missing from the last known address continuously for 5 years or more, or (c) such property having been abandoned, must descend to the State of Delaware as an escheat.

Unlike the New Jersey statutes, which do not limit the definition of “holder” based upon the jurisdiction of organization/incorporation or domicile, the Delaware Code specifically provides that the “issuer of any intangible ownership interest in a corporation, whether or not represented by a stock certificate, which is registered on stock transfer or other like books of the issuer or its agent, shall be deemed a “holder” of such property (Section 1198(7) definition of “holder”).”

Since the obligations to (a) report with respect to the abandoned property and (b) pay or deliver such property under the Delaware Code fall on the “holder” of the property, it does not appear that the Delaware law applies to our circumstance where the issuer corporation is a New Jersey corporation, which is not considered a “holder” under the Delaware Code.

Conclusion: Based upon the interpretation of the applicable sections of the statutes above, after three (3) years from the date the Parent or Company contacted, for disbursement of the merger consideration, the previous shareholders of the Company known to the Company or Parent as domiciled in New Jersey, who have failed to submit the required documentation, the presumption of abandonment arises, which obligates the Company/Parent to (a) report to the Treasurer of the State of New Jersey concerning the property, (b) send written notice to the apparent owner at the last known address informing the owner that the Company/Parent is in possession of property, and (c) deliver to the Treasurer of the State of New Jersey all of the unclaimed property set forth in the report (the pro rata merger consideration for each such shareholder) and all accretions thereon.

Tax - F Reorganization - Deferring Tax Obligations of Target Company's Equity Holders

Under F reorganization (IRC 368(a)(1)(F)), the equity holders of Target first transfer all of their equity interest to a newly formed corporation, Newco. This first step can be accomplished either by a direct transfer in exchange for Newco Stock, or by Newco setting up a new subsidiary that merges with and into Target, with Target equity holders receiving Newco stock in the merger.

Next, Target converts into a Target LLC wholly owned by Newco. These two steps constitute the so-called F reorganization. For tax purposes, after these two steps, Newco is considered to be a continuation of the same corporation as Target, and the assets owned by the Target LLC are treated as being owned by Newco.

Then, Newco sells all of the Target LLC (think of this like an asset holding vehicle) ownership interests to Buyer. Newco's sale of the Target LLC ownership interests to Buyer is treated as a sale of the assets of the Target LLC to Buyer (step up basis for Buyer).

Advantages of this F reorganization includes:

• No physical transfer of assets to Buyer
• No deemed liquidation of Target unlike in other instances where a physical transfer of assets are avoided; that is, Newco may stay alive with the cash proceeds of the sale of the Target LLC ownership interests, thus avoiding tax on the proceeds of the sale from the seller equity holders' perspective
• Newco is able to retain those assets not sold to Buyer without any tax on such assets because during the period in which Target is an LLC wholly owned by Newco, Target LLC is treated as part of Newco and therefore can distribute assets to Newco without tax consequences. Newco then can sell the interests in Target LLC and is treated as selling the assets held by Target LLC.

Ex. Sole member (Seller) of an IA LLC (S corp) plans to sell all of his membership interests therein to Buyer. Seller sets up a DE corp (S corp) as the Newco to retain the sale proceeds therein (not a liquidation, no taxable event). Since S corp IA LLC (Opco) may not have a corporate member-owner, Seller converts IA LLC to IA corporation and Newco immediately elects to treat IA corporation as a qualified S corp (Q-sub) as defined under IRC 1361(b)(3). Seller transfer all of his shares in IA corporation (Q-sub) to Newco (1st step of F reorg). IA corporation converts to a DE LLC (2nd step of F reorg), which terminates the Q-sub election. 

If a Q-Sub election terminates, the former Q-Sub (IA corporation) is treated as a new corporation (DE LLC) acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation (to be held by the S corporation parent). (26 C.F.R. 1.1361-5 - Termination of QSub election).

Newco then sells all of its membership interests in the DE LLC to Buyer.

Tax - Treasury Regulations of Incentive Stock Options and Plans

§1.422-2   Incentive stock options defined.

(a) Incentive stock option defined—(1) In general. The term incentive stock option means an option that meets the requirements of paragraph (a)(2) of this section on the date of grant. An incentive stock option is also subject to the $100,000 limitation described in §1.422-4. An incentive stock option may contain a number of permissible provisions that do not affect the status of the option as an incentive stock option. See §1.422-5 for rules relating to permissible provisions of an incentive stock option.

(2) Option requirements. To qualify as an incentive stock option under this section, an option must be granted to an individual in connection with the individual's employment by the corporation granting such option (or by a related corporation as defined in §1.421-1(i)(2)), and granted only for stock of any of such corporations. In addition, the option must meet all of the following requirements—

(i) It must be granted pursuant to a plan that meets the requirements described in paragraph (b) of this section;

(ii) It must be granted within 10 years from the date of the adoption of the plan or the date such plan is approved by the stockholders, whichever is earlier (see paragraph (c) of this section);

(iii) It must not be exercisable after the expiration of 10 years from the date of grant (see paragraph (d) of this section);

(iv) It must provide that the option price per share is not less than the fair market value of the share on the date of grant (see paragraph (e) of this section);

(v) By its terms, it must not be transferrable by the individual to whom the option is granted other than by will or the laws of descent and distribution, and must be exercisable, during such individual's lifetime, only by such individual (see §§1.421-1(b)(2) and 1.421-2(c)); and

(vi) Except as provided in paragraph (f) of this section, it must be granted to an individual who, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing such individual or of any related corporation of such corporation.

(3) Amendment of option terms. Except as otherwise provided in §1.424-1, the amendment of the terms of an incentive stock option may cause it to cease to be an option described in this section. If the terms of an option that has lost its status as an incentive stock option are subsequently changed with the intent to re-qualify the option as an incentive stock option, such change results in the grant of a new option on the date of the change. See §1.424-1(e).

(4) Terms provide option not an incentive stock option. If the terms of an option, when granted, provide that it will not be treated as an incentive stock option, such option is not treated as an incentive stock option.

(b) Option plan—(1) In general. An incentive stock option must be granted pursuant to a plan that meets the requirements of this paragraph (b). The authority to grant other stock options or other stock-based awards pursuant to the plan, where the exercise of such other options or awards does not affect the exercise of incentive stock options granted pursuant to the plan, does not disqualify such incentive stock options. The plan must be in writing or electronic form, provided that such writing or electronic form is adequate to establish the terms of the plan. See §1.422-5 for rules relating to permissible provisions of an incentive stock option.

(2) Stockholder approval. (i) The plan required by this paragraph (b) must be approved by the stockholders of the corporation granting the incentive stock option within 12 months before or after the date such plan is adopted. Ordinarily, a plan is adopted when it is approved by the granting corporation's board of directors, and the date of the board's action is the reference point for determining whether stockholder approval occurs within the applicable 24-month period. However, if the board's action is subject to a condition (such as stockholder approval) or the happening of a particular event, the plan is adopted on the date the condition is met or the event occurs, unless the board's resolution fixes the date of approval as the date of the board's action.

(ii) For purposes of paragraph (b)(2)(i) of this section, the stockholder approval must comply with the rules described in §1.422-3.

(iii) The provisions relating to the maximum aggregate number of shares to be issued under the plan (described in paragraph (b)(3) of this section) and the employees (or class or classes of employees) eligible to receive options under the plan (described in paragraph (b)(4) of this section) are the only provisions of a stock option plan that, if changed, must be re-approved by stockholders for purposes of section 422(b)(1). Any increase in the maximum aggregate number of shares that may be issued under the plan (other than an increase merely reflecting a change in the number of outstanding shares, such as a stock dividend or stock split), or change in the designation of the employees (or class or classes of employees) eligible to receive options under the plan is considered the adoption of a new plan requiring stockholder approval within the prescribed 24-month period. In addition, a change in the granting corporation or the stock available for purchase or award under the plan is considered the adoption of a new plan requiring new stockholder approval within the prescribed 24-month period. Any other changes in the terms of an incentive stock option plan are not considered the adoption of a new plan and, thus, do not require stockholder approval.

(3) Maximum aggregate number of shares. (i) The plan required by this paragraph (b) must designate the maximum aggregate number of shares that may be issued under the plan through incentive stock options. If nonstatutory options or other stock-based awards may be granted, the plan may separately designate terms for each type of option or other stock-based awards and designate the maximum number of shares that may be issued under such option or other stock-based awards. Unless otherwise specified, all terms of the plan apply to all options and other stock-based awards that may be granted under the plan.

(ii) A plan that merely provides that the number of shares that may be issued as incentive stock options under such plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy the requirement that the plan state the maximum aggregate number of shares that may be issued under the plan. However, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares available for grants under the plan may increase annually by a specified percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan. A plan which provides that the maximum aggregate number of shares that may be issued as incentive stock options under the plan may change based on any other specified circumstances satisfies the requirements of this paragraph (b)(3) only if the stockholders approve an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event.

(iii) It is permissible for the plan to provide that, shares purchasable under the plan may be supplied to the plan through acquisitions of stock on the open market; shares purchased under the plan and forfeited back to the plan; shares surrendered in payment of the exercise price of an option; shares withheld for payment of applicable employment taxes and/or withholding obligations resulting from the exercise of an option.

(iv) If there is more than one plan under which incentive stock options may be granted and stockholders of the granting corporation merely approve a maximum aggregate number of shares that are available for issuance under such plans, the stockholder approval requirements described in paragraph (b)(2) of this section are not satisfied. A separate maximum aggregate number of shares available for issuance pursuant to incentive stock options must be approved for each plan.

(4) Designation of employees. The plan described in this paragraph (b), as adopted and approved, must indicate the employees (or class or classes of employees) eligible to receive the options or other stock-based awards to be granted under the plan. This requirement is satisfied by a general designation of the employees (or the class or classes of employees) eligible to receive options or other stock-based awards under the plan. Designations such as “key employees of the grantor corporation”; “all salaried employees of the grantor corporation and its subsidiaries, including subsidiaries which become such after adoption of the plan;” or “all employees of the corporation” meet this requirement. This requirement is considered satisfied even though the board of directors, another group, or an individual is given the authority to select the particular employees who are to receive options or other stock-based awards from a described class and to determine the number of shares to be optioned or granted to each such employee. If individuals other than employees may be granted options or other stock-based awards under the plan, the plan must separately designate the employees or classes of employees eligible to receive incentive stock options.

(5) Conflicting option terms. An option on stock available for purchase or grant under the plan is treated as having been granted pursuant to a plan even if the terms of the option conflict with the terms of the plan, unless such option is granted to an employee who is ineligible to receive options under the plan, options have been granted on stock in excess of the aggregate number of shares which may be issued under the plan, or the option provides otherwise.

(6) The following examples illustrate the principles of this paragraph (b):

Example 1. Stockholder approval. (i) S Corporation is a subsidiary of P Corporation, a publicly traded corporation. On January 1, 2006, S adopts a plan under which incentive stock options for S stock are granted to S employees.

(ii) To meet the requirements of paragraph (b)(2) of this section, the plan must be approved by the stockholders of S (in this case, P) within 12 months before or after January 1, 2006.

(iii) Assume the same facts as in paragraph (i) of this Example 1, except that the plan was adopted on January 1, 2010. Assume further that the plan was approved by the stockholders of S (in this case, P) on March 1, 2010. On January 1, 2012, S changes the plan to provide that incentive stock options for P stock will be granted to S employees under the plan. Because there is a change in the stock available for grant under the plan, the change is considered the adoption of a new plan that must be approved by the stockholder of S (in this case, P) within 12 months before or after January 1, 2012.

Example 2. Stockholder approval. (i) Assume the same facts as in paragraph (i) of Example 1, except that on March 15, 2007, P completely disposes of its interest in S. Thereafter, S continues to grant options for S stock to S employees under the plan.

(ii) The new S options are granted under a plan that meets the stockholder approval requirements of paragraph (b)(2) of this section without regard to whether S seeks approval of the plan from the stockholders of S after P disposes of its interest in S.

(iii) Assume the same facts as in paragraph (i) of this Example 2, except that under the plan as adopted on January 1, 2006, only options for P stock are granted to S employees. Assume further that after P disposes of its interest in S, S changes the plan to provide for the grant of options for S stock to S employees. Because there is a change in the stock available for purchase or grant under the plan, under paragraph (b)(2)(iii) of this section, the stockholders of S must approve the plan within 12 months before or after the change to the plan to meet the stockholder approval requirements of paragraph (b) of this section.

Example 3. Stockholder approval. (i) Corporation X maintains a plan under which incentive stock options may be granted to all eligible employees. Corporation Y does not maintain an incentive stock option plan. On May 15, 2006, Corporation X and Corporation Y consolidate under state law to form one corporation. The new corporation will be named Corporation Y. The consolidation agreement describes the Corporation X plan, including the maximum aggregate number of shares available for issuance pursuant to incentive stock options after the consolidation and the employees eligible to receive options under the plan. Additionally, the consolidation agreement states that the plan will be continued by Corporation Y after the consolidation and incentive stock options will be issued by Corporation Y. The consolidation agreement is unanimously approved by the shareholders of Corporations X and Y on May 1, 2006. Corporation Y assumes the plan formerly maintained by Corporation X and continues to grant options under the plan to all eligible employees.

(ii) Because there is a change in the granting corporation (from Corporation X to Corporation Y), under paragraph (b)(2)(iii) of this section, Corporation Y is considered to have adopted a new plan. Because the plan is fully described in the consolidation agreement, including the maximum aggregate number of shares available for issuance pursuant to incentive stock options and employees eligible to receive options under the plan, the approval of the consolidation agreement by the shareholders constitutes approval of the plan. Thus, the shareholder approval of the consolidation agreement satisfies the shareholder approval requirements of paragraph (b)(2) of this section, and the plan is considered to be adopted by Corporation Y and approved by its shareholders on May 1, 2006.

Example 4. Maximum aggregate number of shares. X Corporation maintains a plan under which statutory options and nonstatutory options may be granted. The plan designates the number of shares that may be used for incentive stock options. Because the maximum aggregate number of shares that will be used for incentive stock options is designated in the plan, the requirements of paragraph (b)(3) of this section are satisfied.

Example 5. Maximum aggregate number of shares. Y Corporation adopts an incentive stock option plan on November 1, 2006. On that date, there are two million outstanding shares of Y Corporation stock. The plan provides that the maximum aggregate number of shares that may be issued under the plan may not exceed 15% of the outstanding number of shares of Y Corporation on November 1, 2006. Because the maximum aggregate number of shares that may be issued under the plan is designated in the plan, the requirements of paragraph (b)(3) of this section are met.

Example 6. Maximum aggregate number of shares. (i) B Corporation adopts an incentive stock option plan on March 15, 2005. The plan provides that the maximum aggregate number of shares available for issuance under the plan is 50,000, increased on each anniversary date of the adoption of the plan by 5 percent of the then-outstanding shares.

(ii) Because the maximum aggregate number of shares is not designated under the plan, the requirements of paragraph (b)(3) of this section are not met.

(iii) Assume the same facts as in paragraph (i) of this Example 6, except that the plan provides that the maximum aggregate number of shares available under the plan is the lesser of (a) 50,000 shares, increased each anniversary date of the adoption of the plan by 5 percent of the then-outstanding shares, or (b) 200,000 shares. Because the maximum aggregate number of shares that may be issued under the plan is designated as the lesser of one of two numbers, one of which provides an immediately determinable maximum aggregate number of shares that may be issued under the plan in any event, the requirements of paragraph (b)(3) of this section are met.

(c) Duration of option grants under the plan. An incentive stock option must be granted within 10 years from the date that the plan under which it is granted is adopted or the date such plan is approved by the stockholders, whichever is earlier. To grant incentive stock options after the expiration of the 10-year period, a new plan must be adopted and approved.

(d) Period for exercising options. An incentive stock option, by its terms, must not be exercisable after the expiration of 10 years from the date such option is granted, or 5 years from the date such option is granted to an employee described in paragraph (f) of this section. An option that does not contain such a provision when granted is not an incentive stock option.

(e) Option price. (1) Except as provided by paragraph (e)(2) of this section, the option price of an incentive stock option must not be less than the fair market value of the stock subject to the option at the time the option is granted. The option price may be determined in any reasonable manner, including the valuation methods permitted under §20.2031-2 of this chapter, so long as the minimum price possible under the terms of the option is not less than the fair market value of the stock on the date of grant. For general rules relating to the option price, see §1.421-1(e). For rules relating to the determination of when an option is granted, see §1.421-1(c).

(2)(i) If a share of stock is transferred to an individual pursuant to the exercise of an option which fails to qualify as an incentive stock option merely because there was a failure of an attempt, made in good faith, to meet the option price requirements of paragraph (e)(1) of this section, the requirements of such paragraph are considered to have been met. Whether there was a good-faith attempt to set the option price at not less than the fair market value of the stock subject to the option at the time the option was granted depends on the relevant facts and circumstances.

(ii) For publicly held stock that is actively traded on an established market at the time the option is granted, determining the fair market value of such stock by the appropriate method described in §20.2031-2 of this chapter establishes that a good-faith attempt to meet the option price requirements of this paragraph (e) was made.

(iii) For non-publicly traded stock, if it is demonstrated, for example, that the fair market value of the stock at the date of grant was based upon an average of the fair market values as of such date set forth in the opinions of completely independent and well-qualified experts, such a demonstration generally establishes that there was a good-faith attempt to meet the option price requirements of this paragraph (e). The optionee's status as a majority or minority stockholder may be taken into consideration.

(iv) Regardless of whether the stock offered under an option is publicly traded, a good-faith attempt to meet the option price requirements of this paragraph (e) is not demonstrated unless the fair market value of the stock on the date of grant is determined with regard to nonlapse restrictions (as defined in §1.83-3(h)) and without regard to lapse restrictions (as defined in §1.83-3(i)).

(v) Amounts treated as interest and amounts paid as interest under a deferred payment arrangement are not includible as part of the option price. See §1.421-1(e)(1). An attempt to set the option price at not less than fair market value is not regarded as made in good faith where an adjustment of the option price to reflect amounts treated as interest results in the option price being lower than the fair market value on which the option price was based.

(3) Notwithstanding that the option price requirements of paragraphs (e)(1) and (2) of this section are satisfied by an option granted to an employee whose stock ownership exceeds the limitation provided by paragraph (f) of this section, such option is not an incentive stock option when granted unless it also complies with paragraph (f) of this section. If the option, when granted, does not comply with the requirements described in paragraph (f) of this section, such option can never become an incentive stock option, even if the employee's stock ownership does not exceed the limitation of paragraph (f) of this section when such option is exercised.

(f) Options granted to certain stockholders. (1) If, immediately before an option is granted, an individual owns (or is treated as owning) stock possessing more than 10 percent of the total combined voting power of all classes of stock of the corporation employing the optionee or of any related corporation of such corporation, then an option granted to such individual cannot qualify as an incentive stock option unless the option price is at least 110 percent of the stock's fair market value on the date of grant and such option by its terms is not exercisable after the expiration of 5 years from the date of grant. For purposes of determining the minimum option price for purposes of this paragraph (f), the rules described in paragraph (e)(2) of this section, relating to the good-faith determination of the option price, do not apply.

(2) For purposes of determining the stock ownership of the optionee, the stock attribution rules of §1.424-1(d) apply. Stock that the optionee may purchase under outstanding options is not treated as stock owned by the individual. The determination of the percentage of the total combined voting power of all classes of stock of the employer corporation (or of its related corporations) that is owned by the optionee is made with respect to each such corporation in the related group by comparing the voting power of the shares owned (or treated as owned) by the optionee to the aggregate voting power of all shares of each such corporation actually issued and outstanding immediately before the grant of the option to the optionee. The aggregate voting power of all shares actually issued and outstanding immediately before the grant of the option does not include the voting power of treasury shares or shares authorized for issue under outstanding options held by the individual or any other person.

(3) Examples. The rules of this paragraph (f) are illustrated by the following examples:

Example 1. (i) E, an employee of M Corporation, owns 15,000 shares of M Corporation common stock, which is the only class of stock outstanding. M has 100,000 shares of its common stock outstanding. On January 1, 2005, when the fair market value of M stock is $100, E is granted an option with an option price of $100 and an exercise period of 10 years from the date of grant.

(ii) Because E owns stock possessing more than 10 percent of the total combined voting power of all classes of M Corporation stock, M cannot grant an incentive stock option to E unless the option is granted at an option price of at least 110 percent of the fair market value of the stock subject to the option and the option, by its terms, expires no later than 5 years from its date of grant. The option granted to E fails to meet the option-price and term requirements described in paragraph (f)(1) of this section and, thus, the option is not an incentive stock option.

(iii) Assume the same facts as in paragraph (i) of this Example 1, except that E's father and brother each owns 7,500 shares of M Corporation stock, and E owns no M stock in E's own name. Because under the attribution rules of §1.424-1(d), E is treated as owning stock held by E's parents and siblings, M cannot grant an incentive stock option to E unless the option price is at least 110 percent of the fair market value of the stock subject to the option, and the option, by its terms, expires no later than 5 years from the date of grant.

Example 2. Assume the same facts as in paragraph (i) of this Example 1. Assume further that M is a subsidiary of P Corporation. Regardless of whether E owns any P stock and the number of P shares outstanding, if P Corporation grants an option to E which purports to be an incentive stock option, but which fails to meet the 110-percent-option-price and 5-year-term requirements, the option is not an incentive stock option because E owns more than 10 percent of the total combined voting power of all classes of stock of a related corporation of P Corporation (i.e., M Corporation). An individual who owns (or is treated as owning) stock in excess of the ownership specified in paragraph (f)(1) of this section, in any corporation in a group of corporations consisting of the employer corporation and its related corporations, cannot be granted an incentive stock option by any corporation in the group unless such option meets the 110-percent-option-price and 5-year-term requirements of paragraph (f)(1) of this section.

Example 3. (i) F is an employee of R Corporation. R has only one class of stock, of which 100,000 shares are issued and outstanding. F owns no stock in R Corporation or any related corporation of R Corporation. On January 1, 2005, R grants a 10-year incentive stock option to F to purchase 50,000 shares of R stock at $3 per share, the fair market value of R stock on the date of grant of the option. On April 1, 2005, F exercises half of the January option and receives 25,000 shares of R stock that previously were not outstanding. On July 1, 2005, R grants a second 50,000 share option to F which purports to be an incentive stock option. The terms of the July option are identical to the terms of the January option, except that the option price is $3.25 per share, which is the fair market value of R stock on the date of grant of the July option.

(ii) Because F does not own more than 10% of the total combined voting power of all classes of stock of R Corporation or any related corporation on the date of the grant of the January option and the pricing requirements of paragraph (e) of this section are satisfied on the date of grant of such option, the unexercised portion of the January option remains an incentive stock option regardless of the changes in F's percentage of stock ownership in R after the date of grant. However, the July option is not an incentive stock option because, on the date that it is granted, F owns 20 percent (25,000 shares owned by F divided by 125,000 shares of R stock issued and outstanding) of the total combined voting power of all classes of R Corporation stock and, thus the pricing requirements of paragraph (f)(1) of this section are not met.

(iii) Assume the same facts as in paragraph (i) of this Example 3 except that the partial exercise of the January incentive stock option on April 1, 2003, is for only 10,000 shares. Under these circumstances, the July option is an incentive stock option, because, on the date of grant of the July option, F does not own more than 10 percent of the total combined voting power (10,000 shares owned by F divided by 110,000 shares of R issued and outstanding) of all classes of R Corporation stock.

[T.D. 9144, 69 FR 46412, Aug. 3, 2004; T.D. 9471, 74 FR 59077, Nov. 17, 2009]

Why Investing Companies Care About 20% Voting Power Threshold in Portfolio Companies

If a company/venture capital firm/other fund invests in another firm, whether it's for certain strategic purposes or for a return on investment, that investment must be accounted for on the investing firm’s balance sheet. Accounting rules dictate the method to use to report the investment. Either the cost method and the equity method applies when your ownership interest in the other company is less than a controlling financial interest (more than 50% of the investee’s equity).

Presumption of Ability to Exercise Significant Influence at 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of 20% or greater of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investor has the ability to exercise significant influence over the portfolio company, in which case the investor must apply the “equity method” of accounting to the investment. With the equity method, the balance sheet value of the investment changes according to the net income (the profit) of the portfolio company and report the gain as revenue on your income statement. For example, if the portfolio company had a net loss in a fiscal year, the investor would decrease the value of the investment by its share of the loss (pro rata) on the balance sheet and report the decline as an expense on its income statement. On the other hand, if the portfolio company had a net income in a fiscal year, the investor would increase the value of the investment by its share of the income (pro rata) on its balance sheet and report the gain as revenue on its income statement. Dividends from the investment are considered a return on invested capital, not revenue. The investor would decrease the value of the investment by the amount of any dividends received.

The equity method may be required for investments in certain types of entities at much lower ownership levels than 20%. For example, investments in LP, LLC, trust or other structures that maintain specific ownership accounts are accounted for using the equity method when the investor has an ownership interest of 3% to 5% or greater.

Presumption of Passive Investment at less than 20% Voting Power – may be overcome based on facts and circumstances

A stock investment in a corporate entity (portfolio company) that results in an ownership of less than 20% of the portfolio company’s outstanding shares of voting stock leads to a presumption that the investment is passive investment, in which case either cost (ASC-325-20) or fair value (ASC 320) method applies based upon the nature of the investment.

ASC 320-10-20

Equity Security

“Any security representing an ownership interest in an entity (e.g., common, preferred, or other capital stock) or the right to acquire (e.g., warrants, rights and call options) or dispose of (e.g., put options) an ownership interest in an entity at fixed or determinable prices.” The term, equity security, does not include the following:

·         Written equity options (because they represent obligations of the writer, not investments)

·         Cash-settled options on equity securities or options on equity-based indexes (because those instruments do not represent ownership interest in an entity)

·         Convertible debt or preferred stock that by its terms either must be redeemed by the issuer or is redeemable at the option of the investor

How to Set Exercise Price of Underlying Shares in Granting Stock Options as Compensation

The answer is by a reasonable valuation method to make it fair market value at the time of the grant. Recipients of stock options with exercise prices that cannot be shown to be at or above the “reasonably-determined FMV” on the date of grant face immediate tax on vesting at a combined federal and state tax rate as high as 85% or more.

An issuer of stock options may avoid such issue by using an IRS-approved valuation method, which shifts the burden of proof that the FMV determination method was reasonable or unreasonable from the issuer to the IRS, reducing the likelihood of successful challenges by the IRS.

Section 409A (https://www.irs.gov/irb/2007-19_IRB/ar07.html) of the Internal Revenue Code and Some State Laws

·         From Option Holder’s Perspective

Section 409A requires an option holder with an option having an exercise price below FMV at the time of grant to recognize the taxable income (federal income and employment taxes) equal to the spread between the FMV and the exercise price (FMV – exercise price) as they vest, not at the time the holder exercises the option nor at the time the holder dispose of the shares underlying the options.

Moreover, an additional 20% + federal tax also applies as the option vests. Certain states like California will also have parallel statutes that impose additional 20% + state tax on top of the state regular income and employment taxes.

·         From Issuer’s Perspective

For companies granting stock options to its employees and withholding the income and employment taxes, upon failure to properly withhold these taxes, such companies could be liable for these taxes plus penalties and interest.

Establishing a Defensible FMV

Section 409A approves three valuation methods as reasonable. Such valuations are valid up to 12 months unless there are intervening events that would reasonably and materially impact the valuations (e.g., (e.g., the resolution of material litigation, the issuance of a material patent, a financing, an acquisition, a new material customer or other significant corporate event).

·         Formula-based Valuation: not commonly used

·         Independent Expert Valuation: Section 409A allows the FMV to be established presumptively by qualified independent valuation experts using certain methods recognized under the IRC.

·         Illiquid Startup Inside Valuation.  A valuation will also be presumed to meet the requirements of Section 409A if it was prepared by someone that the company issuer reasonably determines is qualified to perform such a valuation based on “significant knowledge, experience, education or training.”  Section 409A defines “significant experience” to mean at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the company’s industry. This person does not need to be independent from the company. However, in order to rely on the illiquid startup insider valuation safe harbor:

ü  the company must have been conducting business for less than 10 years;

ü  the company may not have a class of securities that are traded on an established securities market;

ü  neither the company, nor the recipient of the option, “may reasonably anticipate” that the company will be acquired within 90 days or go public within 180 days; and

ü  the common stock must not be subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost)

Restricted Stock as Alternative, Not Subject to 409A

Shares of restricted stock are not subject to Section 409A of the IRC. A recipient of shares of restricted stock may file an “election under Section 83(b) of the IRC to be taxed” in the year the election is made on the spread between the purchase price and the FMV as of the date of grant (typically nominal or zero) rather than being taxed, when the restriction on the shares lapses, on the spread between the purchase price and the FMV at the time of such lapses (when the shares are hopefully worth more).