409a Valuation

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Internal Revenue Code (IRC) Section 409A regulates the treatment of nonqualified deferred compensation (NQDC) paid by a “service recipient” to a “service provider” for federal income tax purposes. Sec. 409A has a measurable impact on the way NQDC plans are designed and operated. Failure to adhere to Sec. 409A could result in immediate taxation, a 20% penalty and potential interest payments to the employee. The context in which most commonly encounter Sec. 409A regulations is related to the issuance of employee stock options and other equity instruments.

A 409A valuation is a common stock valuation. Required by Sarbanes Oxley, a 409A valuation is used to value stock options for employees in pre-publicly traded companies. But a 409A valuation is much more than just a required compliance document: it is something that will affect every one of your employees who has stock options—and it’s something that, like it or not, your board members are going to have a vested interest in.
Because the 409A valuation is a regulated valuation, there are certain times when it is common to have a valuation done, such as every 12 months or after any significant event. Any time you give employees stock options, you need a 409A valuation.
In order to complete the valuation process, you’ll need to gather non-financial criteria, in addition to financial criteria. And, needless to say, accuracy is paramount. You don’t want to find yourself going down the path if you have failed to accurately value your options.

When issuing stock options, companies must be aware of the following requirements of 409a:

1. The fair market value must be determined using "reasonable application of a reasonable valuation method;"

2. a valuation needs to be performed by someone qualified to perform such a valuation, based on her knowledge, training, experience, etc. (In most cases, companies choose to hire outside appraisal firms to meet this requirement);

3. and
the valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (e.g., new rounds of financing, new product launches, new major customers, etc).

409a Valuation Steps

In order to comply with 409A, a company may hire a third-party appraiser to perform a valuation. This valuation will ultimately be reviewed by several parties, which could include management, Internal Revenue Service, the company’s auditors or even the SEC. The following represents a non-exhaustive checklist of items that you, as a reviewer of the appraisal, may want to consider.

  • Is the appraiser qualified?
    • Does the appraiser have previous experience performing 409A valuations? If not, does the appraiser have significant valuation experience that would suggest his/her competency? Has the appraiser’s work been successfully reviewed by auditors?
  • Is the valuation date recent to the grant date?
    • Is the valuation date no more than 12 months prior to the grant date for the options?
    • Have any significant events occurred between the valuation date and the grant date that might affect value?
  • Is the appraiser employing appropriate methodologies to value the common stock? There are generally two steps involved with this type of analysis.
    • The first step involves determining the overall company value.
    • The second step involves allocating the total company value among the various capital owners (e.g., preferred and common shareholders). As outlined in the American Institute of Certified Public Accountants (AICPA) guidelines, the three most commonly used valuation methodologies for the second step are the option-pricing model, probability weighted expected return model and the current value method. Note, the current value method is only appropriate in limited circumstances.
  • Does the appraiser support his/her concluded marketability discount using evidence other than quantitative methods?
    • Many appraisers rely solely on quantitative methods such as put option models to quantify the marketability discount in a 409A analysis; however, IRS will look for evidence beyond quantitative models (e.g., an analysis of restricted stock studies) to support the concluded discount.
  • Did the appraiser consider any recent rounds of financing or recent transactions of the company’s common stock?
    • Has the company had a recent round of financing that it views as arms-length and indicative of fair market value? If so, the appraiser will need to consider the round of financing in the valuation, and may need to rely on the pricing of the round to deduce the common stock value.
    • The secondary transaction market has grown considerably over the last few years, and private company common stock is increasingly being traded over secondary exchanges or otherwise sold to private buyers. The appraiser will need to consider whether this transaction is a relevant indication of value, which can be driven by factors such as the motivations of the buyer and seller, the block size, the level of due diligence performed and other factors.
  • Can the valuation be used for both tax reporting and financial reporting purposes?
    • If you intend to use the appraisal to support your Accounting Standards Codification Topic 718 stock compensation expense (formerly known as SFAS 123R), the appraisal needs to state that it is valid for both tax and financial reporting purposes.

Primary Factors that Influence Common Stock Value

There are a number of factors that impact a company’s common stock value. While the magnitude and directional impact of these factors can vary depending on a company’s capital structure, stage of development, etc., these factors generally have the following impact on value:

  • Company Value: Any factor that increases the overall company value (e.g., faster growth or greater profitability) will increase the common stock value.
  • Preferred Stock Participation Feature: Most preferred shares contain a conversion option that allows the owner to convert his/her preferred shares into common shares. Some preferred shares, however, have a participation feature allowing them to share in any upside with the common shares without the exercise of the embedded conversion rights (i.e., “they get to have their cake and eat it too”). The presence of this type of participation feature ultimately increases the value of the preferred shares and reduces the value of the common shares.
  • Preferred Stock Cumulative Dividends: When a company has preferred stock with cumulative dividends, a larger portion of any sale/initial public offering proceeds will be distributed to preferred stock, thereby reducing the remaining value available to the common stock.
  • Sale or Transfer Restrictions: The presence of sale/transfer restrictions associated with the company’s common stock will reduce the stock’s attractiveness and, therefore, reduce its value.
  • Control or Voting Rights: In most cases, a single share of common stock does not have significant control or voting rights. The presence of any material control or voting rights will increase the value of the common stocks.

409a Valuation Methodologies
The most viable methods for 409A analyses are conveniently summarized in the AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the “Guidance”). While the Guidance had its origin in the financial reporting realm, it provides a good summary of the required considerations in equity valuation for tax purposes such as 409A. The Guidance suggests that the valuation of equity can essentially be viewed from three distinctly different vantage points, any one of which may provide the “best method” based on the facts and circumstances of the subject company or equity. The following sections summarize these methods.
the “current value method” (CVM)
suggests that the valuation of common equity is a function of the company’s valuation as of the grant date. In other words, the CVM essentially answers the question “What is the value of your equity if the company were sold today?” While the Guidance suggests that this method is most relevant when an actual sale of the company is imminent, its use is not exclusively limited to such a scenario.
the “option pricing method” (OPM)
suggests that the valuation of the common equity can be described as a function of the “optionality” that the common stock has on the future net asset value of the company, given considerations such as senior obligations (debt and preferred equity, for example), estimated time to a sale, and operating volatility of generally similar companies during the interim (which is typically readily observable). In other words, the OPM essentially answers the question “What is the current value of your equity, given your investment horizon, in light of expected operating volatility during the interim?” This method is particularly relevant in cases where there is significant leverage or preferred stock that is senior to the common stock, or it is reasonable to expect future growth in firm operating results and the correlating valuation.
the "probability weighted expected return method” (PWERM) suggests that the valuation of the common equity can be described as a function of discrete valuation outcomes for the company in the future. In other words, the PWERM answers the question “What is the current value of your equity if you can roughly estimate the discrete outcomes and probabilities associated with multiple potential sale scenarios in the future?” This method is particularly relevant in cases where there exists an abnormal distribution of future outcomes, with the “boom” and “bust” value(s), and their respective probabilities, being reasonably estimable.
The use of any of these three valuation methods may be appropriate based on a company’s individual facts and circumstances, and a third party valuation of the stock option shifts the burden of proof to the IRS. In times of economic downturn, many companies adjust their compensation structure to include more stock or incentive based compensation. Before you enter the incentive compensation arena, make sure you plan for the tax consequences.
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