Thanks to the IRS, 409A valuations are a regular part of business for companies that issue stock options to employees. This is the reality for any company that uses stock options as part of its employee compensation, including many early-stage companies.
Businesses that issue stock options should get a valuation at least annually.
IRS Requires 409A Valuations for Stock Options
Internal Revenue Section 409A was passed as part of the 2004 American Jobs Creation Act. On April 10, 2007, the Treasury Department and the IRS issued regulations on the treatment of non-qualified deferred compensation plans under Section 409A.
Under these provisions, all non-qualified plans must comply with Section 409A rules. If businesses fail to comply with 409A, they risk losing the plan’s tax-deferred status.
Losing the tax-deferred status by not complying with 409A will subject participants to having all previous plan deferrals declared immediately taxable at a participant’s regular tax rate, plus a 20% penalty tax.
Basics of 409A Valuations
For stock option recipients to be able to defer the tax on their compensation, the option’s exercise price cannot be lower than the fair market value of the underlying security as of the grant date.
The exercise price is also referred to as the strike price or the price at which underlying security can be purchased or sold when trading a call or put option.
409A Valuations: The Requirement
For a privately-held businesses that issue stock options to employees, a 409A valuation is the most common approach to achieving Section 409A “safe harbor” status. This ensures that the business will not violate the 409A rules.
The IRS does not have mandatory certifications for an appraiser to perform a 409A valuation, but it does require that the appraiser have “significant knowledge, experience, education and training.”
Below are the three steps required to perform a Section 409A valuation.
Calculating Equity Value of the Company for 409A (Step One)
The first step is to estimate the fair market value of the equity of the business. Any of the three methods below can be used subject to the facts and circumstances.
- Cost based – The asset, or cost, approach is based on the premise that a prudent investor would pay no more for an asset than its replacement or reproduction cost. The asset or cost approach is usually appropriate for analyzing holding or real estate investment companies, and less applicable when intangible assets comprise a significant portion of an entity.
- Income based – The income approach estimates the value of a business, business ownership interest, security or assets using one or more methods that convert expected future economic benefits into a single present value. The application of the income approach establishes value by methods that discount or capitalize earnings, and/or cash flows, by a discount or capitalization rate that reflects market rate of return expectations, market conditions, and the relative risk of the investment.
- The market-based approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Two commonly used methods are the merger and acquisition method and the guideline public company method. Another method is the Option Pricing Method (OPM) “backsolve,” which can be applied when there is a recent transaction in a company’s shares between unrelated parties.
Determining the Value of the Common Stock for 409A (Step Two)
The second step is to allocate the equity value between all the different share classes (common, preferred, warrants, etc.) to determine the current value of the common shares. This is done with the Option Pricing Model, or OPM. The allocation is based on the economic relationship between multiple classes of equity securities in a company with a complex capital structure, with the total equity value of the company being a common factor.
The valuation of the stock is done as follows:
- First, valuation breakpoints are determined. This is called the “waterfall.” These are equity values in which the allocation of proceeds in a hypothetical sale shift from one class of equity (or more) to another. Each share type has features such as liquidation preferences, interest/dividend, conversion options, and exercise prices. These rights define the order, values, and amounts at which each class of security is entitled to a share of equity value. The equity values between two breakpoints are referred to as a “tranche.”
- Second, a Black-Scholes options model is used for each tranche, with the breakpoint being the strike price, and the company’s equity value (determined in step 1) being the underlying asset.
- Third, the incremental option value of each tranche is allocated among the equity share groups that participate in the tranche.
Ultimately, the sum of all values assigned to the common units are aggregated as the total common shares value and divided by the total number of common shares to determine the fair market value of one common share on a “as freely traded basis.”
This process is complicated, and the common share value derived could be very sensitive due to its optional nature. It is, therefore, recommended to use an appraiser that specializes in the Option Pricing Model.
Applying a Discount for Lack of Marketability (DLOM) (Step Three)
The final step is to take the calculated fair market value of one common share on the “as freely traded basis” and apply a discount due to the liquidity limitations of a minority interest in a privately held company compared with shares of publicly traded companies.
Does a 409A Valuation Show the Actual Value of a Company?
I am often asked by entrepreneurs and business owners why the equity value used, or implied, in a 409A (or an ASC 718, stock-based compensation for financial reporting purposes) valuation is not necessarily an indication of the value of the equity.
Investment value is the value for a specific buyer that can benefit from unique synergies with the acquired business.
Fair market value (or fair value) of a company is the value from the perspective of a market participant on a controlling basis (excludes any buyer specific synergies).
Since the subject of 409A and ASC 718 valuations is a minority interest in the company (usually one share of common stock) the valuation is done on a minority basis. Business appraisers often use valuation methods that are applied directly to a non-controlling interest, taking into account the economic benefits and risks inherent in owning a non-controlling interest, to derive the “as freely traded” marketable value of the minority interest (the third level), and then apply a discount for lack of marketability to account for liquidity issues associated with minority interest in a privately held entity (the forth level).
Therefore, a 409A analysis cannot be used as an indication of the value of the company.
This article was written by Liron Sharon of YMS Value, LLC. Massey and Company CPA collaborates with Liron and YMS Value, LLC on business valuations, including 409A valuations for businesses that issue stock options to employees.
YMS Value is a business valuations and advisory firm providing a broad range of business valuations and advisory services.
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