Over the past few years, granting stock options has become an important aspect of employees’ compensation, and also an important tool in assisting employers to attract and retain talented employees (and/or contractors). Compensation via stock options is defined as deferred compensation. Deferred compensation plans can be qualifying or non-qualifying, with 409A plans being non-qualified. Internal Revenue Section 409A was passed as part of the 2004 American Jobs Creation Act, and on April 10, 2007, the Treasury Department and the IRS issued regulations on the treatment of non-qualified deferred compensation plans under Section 409A. All non-qualified plans must comply with Section 409A rules or risk losing the tax-deferred status of the plan and subject participants to having all previous plan deferrals declared immediately taxable at a participant’s regular tax rate plus a 20% penalty tax.
In order for the options recipients to be able to defer the tax on their compensation, the exercise price of the option (also referred to as the strike price, or the price at which an underlying security can be purchased or sold when trading a call or put option, respectively) cannot be lower than the fair market value of the underlying security as of the grant date. For a privately-held company, the 409A valuation is the most common approach to achieving Section 409A “safe harbor” status. 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.”
There are three steps in performing a Section 409A valuation:
1. Calculate equity value of the company. The following methods are used to estimate the fair market value of equity:
a. 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 to use for analyzing holding companies or real estate investment companies, and less applicable when intangible assets comprise a significant portion of an entity.
b. 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.
c. 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, it can be applied when there is a recent transaction in a company’s shares between unrelated parties.
2. Determine the value of the common stock. The second step is to allocate the equity value between all the different share classes (common, preferred, warrant, etc.) to determine the current value of the common shares, this is done with the 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.
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.
3. Apply a discount for lack of marketability (DLOM). 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.