By Channing Hamlet
Managing Director, Objective Capital Partners
In the wake of a number of accounting scandals in the early 2000s (Enron, Tyco, WorldCom), the IRS enacted new legislation, Section 409a, to curb perceived abuses in deferred compensation. This was mainly a reaction to executives of these companies withdrawing significant cash from their deferred compensation plans at a time when the companies were failing and shareholders were left holding the bag.
In typical IRS fashion, the reaction was significant and far-reaching. As a result, Section 409a is a large and relatively complex body of legislation. To boil it down to a simple concept: if a company provides guaranteed compensation to a recipient, taxes are due at the time the agreement is made rather than when the compensation is paid.
As part of 409a, beginning December 31, 2008 the IRS required private companies to perform formal valuation analysis when granting stock options to ensure that the strike price of the option is granted at or above fair market value of the Common Stock. Going back to the spirit of 409a described above, if the strike price is below fair market value, the recipient is supposed to recognize income. As part of the 409a regulation, the IRS provides a safe harbor for companies that choose to work with a qualified appraiser.
This regulation resulted in a whole new industry popping up and created a new field in valuation: 409a. A number of firms popped up and the accounting firms and other bodies have stepped in to continue to refine and enhance guidance on appropriate methods for 409a valuation.
After completing more than 500 of these projects serving clients ranging from early stage, pre-finance startups to unicorns that are looking at an Initial Public Offering (IPO), I developed this article to provide an overview of the common methodology used for 409a and the basic process.
The valuation methodology is generally a three step process:
Step 1: Business Enterprise Value.
The overall business value is developed using a traditional valuation framework based on a combination of market comparables, discounted cash flow and asset-based valuation.
- Market Comparables. These valuations are based on a review of either public companies or private transactions to derive multiples of revenue or profit for a particular industry or type of company. These multiples are then applied to the subject company to determine its value.
- Discounted Cash Flow. This valuation is based on a projection of the company’s cash flow and then discounted back to present value using a discount rate. There are a number of assumptions that make this valuation method tricky (discount rate, growth rates, calculation of terminal value, etc.) and so this method is typically used as one of many for a corroboration of value.
- Asset-Based Valuation. In some instances, and for some industries, valuation can be performed using a book value or replacement cost approach. This valuation approach is typically used for early stage companies that do not yet have revenue or companies where the industry is valued based on book value (such as financial services). As such, this is not typically used.
Below is an example enterprise valuation for “Company ABC” where we utilized the market approaches and performed a discounted cash flow to corroborate the value.
Example Valuation Summary
Step 2: Allocation of Value.
For companies that have multiple classes of stock, the next step is to determine the value of each class of stock, taking into account the rights and terms of each class of stock.
There are several methods to choose from here, as follows:
- Option Pricing Model. The most common method used for companies with Preferred Stock is a Black-Sholes based option pricing model. The theory here is that common stock in a company that has Preferred Stock behaves in a similar fashion to a publicly traded stock option. As such, the option pricing method factors in the “option value” of the Common Stock and the liquidation preferences of the Preferred Stock. This is developed by understanding the waterfall and liquidation preferences and modeling a call option at each break point in order to determine the value attributable to each class of stock.
- Current Value Method. The current value method is primarily used for companies that only have one class of stock or are expecting a near term liquidation or exit event.
- PWERM. For companies that have an imminent exit or liquidity event planned, it’s common to use a scenario analysis called a Probability Weighted Expected Return Method (PWERM) where discrete exit scenarios are developed. In each scenario, the value of each class of stock is determined and then discounted back to present value. This is most commonly used for companies that are nearing an IPO or an exit.
Below is an example summary or results for an equity value allocation where we display the implied value of each class of stock- in this case, a company with two classes of Preferred Stock and one class of Common Stock.
Example Equity Allocation
Step 3: Discounts.
Following the determination of the value of each class of share, a discount for lack of marketability is determined and applied to the common stock. This is meant to capture the fact that there would be a cost and time requirement to liquidate a small block of common shares. There are a number of quantitative and qualitative methods to choose from in determining an appropriate discount.
Below is an example of the final calculation of the Common Stock that is used to grant options, reflecting a discount for lack of marketability. In this case, we used a relatively conservative discount of 30.0%.
Example Common Stock Conclusion
It’s important to follow the guidance outlined by the American Institute of Certified Public Accountants (AICPA) to remain compliant with 409a when granting stock options and offering equity compensation to employees. Penalties for recipients of equity compensation that are not compliant with 409a can be significant. In addition to back taxes and penalties that would be owed for non-payment of taxes, there are also provisions for additional 409a penalties that apply to both Federal and some states (for example, in California). Total penalties can equate to 80% or more.
While at a high level, the process is relatively simple, the devil is in the details and it’s important to follow the guidance in developing a defendable and supportable value conclusion.
Channing Hamlet is a Managing Director at Objective Capital Partners, LLC in San Diego, CA where he leads the firms’ valuation practice. Objective Capital is a mergers and acquisitions (M&A) advisory and investment banking firm focused on transactions for companies with enterprise values up to $500 million. Prior to Objective Capital, Mr. Hamlet served as a Managing Director of Cabrillo Advisors, where he was instrumental in growing the valuation practice from its inception to a national practice serving more than 700 clients in five years. Previously, he served as a Principal at the private equity firm LLR Partners and was member Legg Mason’s Investment Banking group. Mr. Hamlet holds FINRA Series 7, 63 and 79 licenses and is a Registered Representative of BA Securities LLC, Member FINRA SIPC. More information on Objective Capital and its valuation practice can be found at https://objectivecp.com///services/business-valuation/.