SECTION 5. EXAMPLE

E is an employee of Corporation A, a publicly traded corporation. On September 1, 2004, in connection with E’s performance of services, A grants E options to purchase 100,000 shares of A stock at $10 per share. The options are exercisable for 10 years. The options will vest on September 1, 2007, if E continues to be employed by A through that date, or on a change in ownership or control, if earlier. Under the terms of the option, if E’s employment is terminated after the option is vested, the option must be exercised on or before the date that is 3 months after the termination of employment.

On September 15, 2005, Corporation B acquires all of the stock of A, and A is merged into B. Contingent on the change in ownership, E’s options become fully vested and are converted into B options with the same aggregate spread and the same ratio between the exercise price and the value of the stock (determined immediately before the conversion). At the time of the vesting, A stock has a fair market value of $20, and B stock has a fair market value of $50. Thus, in connection with the change in ownership, E receives fully vested options for 40,000 shares of B stock with an exercise price of $25. The date of the vesting and substitution is the payment date and, therefore, the valuation date.

Using a valuation method that complies with this revenue procedure, B determines that, as of the valuation date, it is reasonable to assume that the volatility of B stock is .25, that the remaining expected term of the option is 36 months, and that the risk-free interest rate is 5%. B determines that the value of the option is $1,096,000 (or $27.40 per share).

Without regard to the change in ownership, this payment was contingent only on continued performance of services for Corporation A for a specified period of time and the payment is attributable, in part, to the performance of services before the date the payment was made. Therefore,

2003-34 I.R.B. 400 August 25, 2003