On 27 March, French tax authorities updated their official tax bulletin (BOFIP) to clarify the methods for determining the exercise price of business creator share subscription warrants (BSPCE). This is probably a revolution for BSPCEs in France, significantly increasing their attractiveness, but that’s not all. Here are a few prospective thoughts.
Why were these clarifications so eagerly awaited by practitioners?
BSPCEs benefit from a favourable tax and social security regime, subject to compliance with a number of conditions. In particular, the exercise price of BSPCEs must correspond to the value of the underlying share on the date of allocation and may not be less than the price per share resulting from a capital increase that took place less than 6 months previously. However, a discount may be applied in the event of (i) a justifiable loss of value of the company or (ii) a difference in rights between these shares and those underlying the BSPCEs (see III of Article 163 bis G of the French General Tax Code). The latter case is of interest to us.
Failure to comply with this condition means that the gain associated with the BSPCEs may be considered as salary, which could lead to a significant increase in the taxation borne by the BSPCE holder as well as social security contributions payable by the issuing company.
Faced with this major issue, in the absence of details regarding the methods for calculating this discount, cautious practitioners applied no discount or a conservative flat-rate discount, which was often 20%.
Tax authorities now indicate that the exercise price “may in particular be determined at the fair value of the security on the day of allocation, in accordance with the objective financial methods used for the valuation of securities”. It is also accepted that any contractual clause (even if it is not statutory), establishing a difference in law between the shares underlying the BSPCEs and other classes of shares issued by the company, may justify the application of a discount to assess the value of the former (e.g. a preferential liquidation clause or a non-transfer clause).
These few clarifications could well herald a revolution and liberate practitioners, particularly expert evaluators, who have long considered the exercise prices used for BSPCEs to be overvalued, which made them less attractive.
How do these ‘objective financial methods’ work in practice?
The financial characteristics and rights attached to the shares issued during the last capital operation are specific to each company and there is therefore no ‘standard’ universally applicable discount for determining the value of an ordinary share compared to another type of share. To calculate the discounts, valuers use the ‘option pricing’ method: the Black & Scholes model for the preferential liquidation discount, and the Chaffe, Finnerty, Asian and/or Ghaidarov approaches for the illiquidity discount. This financial method is also used in the United States for 409a reports (stock options). We therefore have much to learn from the experience of the last 20 years in the United States since the introduction of Form 409a in 2004 to value stock options. It appears that, on average, the discount applied to determine the value of an ordinary share in relation to the price per share of the last capital transaction (with preferential liquidation attached to these shares) varies between 50% and 70%.
Several parameters have an impact on the discount, including the valuation of the company, the capitalisation table, the preferential liquidation rules (priority payment multiples granted to investors on their investment, participating or not, presence of a carve-out or not), the maturity of the underlying (date from which the company will have a probable exit event), and the volatility of the industry (daily variation in the price of the underlying of comparable listed companies over a period of one year or more). The application of a double discount for preferential liquidation and illiquidity is not automatic. In the case of preferential liquidation, the corresponding discount aims to calculate the difference in value between preference shares and ordinary shares and is systematically combined with an illiquidity discount because the option pricing model presupposes a liquidity of the securities that needs to be adjusted for unlisted companies. In the absence of preferential liquidation, no discount of this type is applicable, and the illiquidity discount is analysed differently depending on the context by weighing up the economic and legal arguments. In this respect, is the illiquidity discount different, for example, depending on whether the beneficiary of the BSPCEs will be an employee or a founder? Indeed, contractual clauses applicable to shares held by a founder differ from those of employees, and liquidity opportunities benefit founders more. However, the quantified impact of these differences is sometimes difficult to determine. Let us simply remember that one single approach does not necessarily apply to all types of BSPCEs of the same company.
The application of these discounts already raises many questions for practitioners and issuing companies.
Should the discounted fair value be used or can a higher exercise price be used? Tax law sets a minimum, but it is entirely possible to use a higher exercise price (in some cases this can facilitate the transition so as not to have a new plan that is better than the old ones).
At what price should the shares held by an employee who leaves the company be bought back? Should discounts for preferential liquidation and illiquidity be taken into account or, on the contrary, excluded? The answer probably depends on both legal constraints and managerial choice, but it will have to be decided in the context of the definition of ‘market value’ within the contractual commitments (or ‘mini-pacts’) signed by BSPCE holders.
Is it necessary to call on an expert valuer? As the tax authorities refer to ‘objective financial methods’, which are complex by definition, this is strongly recommended if the company does not have the necessary in-house expertise.
How long is the expert’s valuation valid for? In our opinion, around 12 months, which is also the accepted period of validity for Form 409a reports in the United States, barring any major events. The completion of a capital raising or another type of capital operation necessarily requires the report to be updated. Time is therefore a genuine issue. This is why it is recommended to carry out regular allocation of lots to employees in order to avoid the deceptive effect of an increase in the exercise price.
What about past BSPCE plans?
As with any revolution, the question of transition arises. Employees who are beneficiaries of old plans that have not been discounted may feel disadvantaged by this paradigm shift. In some (quite frequent) cases, the exercise price of BSPCEs in new plans may even be lower than in previous plans. What can be done in this type of situation?
According to our discussions with tax authorities, they are opposed to a retroactive change in the exercise prices of previous plans. We find this opinion questionable, and it would be advisable for legislators to officially take a position on the matter. Indeed, it should be remembered that the law has already allowed discounts to be applied since 2008. If this amendment is part of a correction process following administrative clarifications, potentially approved by the general meeting of shareholders, nothing seems to prohibit us today from correcting globally and retroactively all the exercise prices of former plans within the limits of what was permitted by law: namely by retaining an exercise price that is not lower than the value of the underlying ordinary share recalculated in light of the circumstances at the time of the allocation of BSPCEs thus corrected.
That said, pending clarification on this matter, in our opinion, companies may, with the agreement of the holders, cancel previous BSPCEs and award new ones with a discounted exercise price on the date of award. However, this is only worthwhile when the discounted exercise price is lower than the exercise price of the previous plan.
We are already seeing many ‘regularisation’ operations of this type. These also raise other questions. For example, on this occasion, does the starting point of the period during which the BSPCE holder gradually acquires the right to exercise his BSPCEs (known as the ‘vesting’ period) necessarily have to be updated and reset to zero? In our opinion, the answer is no, it will solely come down to a managerial decision. As the law does not impose the existence of a vesting period, employers should be free to keep the original start date of this period if they wish.
Could this paradigm shift have an influence beyond the simple context of BSPCEs?
The clarifications provided to the official tax bulletin (BOFiP) pave the way for relatively significant discounts, which will substantially enhance the attractiveness of BSPCEs in France, and it is likely that the principles applicable to BSPCEs will be transposed to other instruments.
In fact, according to our information, tax authorities already recognise that the same principles apply to share subscription warrants (BSA), free shares and stock options. For example, to calculate the value of the free share acquired, which serves as the basis for the 20% employer contribution, it should be accepted that the same discounts are used in the context of BSPCEs.
It is clear that, by choosing to refer to ‘objective financial methods’ rather than proposing discount standards, tax authorities have favoured a detailed approach to the valuation of company shares, taking into account the rights attached to the shares, their liquidity and the circumstances of their ownership. This development has all the hallmarks of a revolution, the practical issues arising from which are still barely being assessed and which we hope to see addressed in the next guide to the valuation of company securities, which is due to be updated by tax authorities in the near future.
Damien Basson, Partner at INLO Avocats
Damien Basson specialises in tax law and corporate law (venture capital), particularly in relation to capital raising, structuring management packages (especially BSPCEs) or executive compensation and assets, sales/acquisitions, corporate tax restructuring (partial contributions of assets, mergers, etc.) and tax litigation
Illan Glaubert, Founding Partner of SoValue
Illan Glaubert is an economist specialising in the valuation of companies and share classes in the tech industry. He assists managers in their capital-sharing transactions (business creator share subscription warrants (BSPCE), free allocations of shares (AGA), share purchase warrants (BSA), stock options).
