March 01, 2011

In developing deferred compensation and employee stock option plans for management, many companies fail to properly consider issues that may arise from improperly performed valuations related to Internal Revenue Code §409A (“409A”) compliance. Failing to comply with 409A can lead to severe penalties, including the acceleration of taxable income, tax penalties, company withholding tax issues, potential exposure for board members, and even the inability or delay in consummating a future transaction. These issues are of particular importance to startups and highly leveraged companies seeking short-term liquidity events.

Overview of IRC Section 409A

Enacted in October 2004 (with final regulations following in April 2007), as a component of the American Jobs Creation Act of 2004 and in the wake of corporate scandals like Enron, 409A was conceived to address perceived abuses of deferred compensation plans. As detailed in the final regulations, 409A applies to deferred compensation arrangements, such as long-term incentive plans, annual performance bonus arrangements, severance agreements, nonqualified retirement plans, and employee stock options.

Among other restrictions and guidelines, the key principle outlined in 409A pertains to the issuance of deferred compensation, particularly employee stock options. Granting employee stock options with exercise prices below the fair market value of the underlying security represents an immediate transfer of value and creates a taxable event.

The penalties for granting options with exercise prices deemed to be below fair market value are severe and include:

  • Immediate taxation of the intrinsic value of the option (i.e., the amount the fair market value exceeds the exercise price)
  • A 20% penalty

In order to avoid running afoul of 409A issues, companies regularly seek the help of valuation professionals in determining fair market value of the underlying securities (e.g., the common stock of the subject company). As presented in the table on the following page, adherence to certain guidelines by the subject company and appraiser will help to ensure that the valuation is presumed reasonable.

Valuation Safe Harbor Principles

Getting it Right the First Time

It is important to note that 409A does not require that an external valuation firm be engaged to perform a valuation. Although many companies hire valuation professionals to perform this work, many early-stage startups perform this work internally due to concerns about compliance costs. 409A requires that the valuation be performed by a qualified person with “significant knowledge and experience” performing such valuations.

A recent survey indicated that CFOs view 409A valuations as simply a compliance checkmark, with 67% singling out cost as the key factor in choosing a vendor.1 Only 12% of CFOs surveyed viewed quality as a determining factor, and few firms are aware of any IRS audits or reviews of deferred compensation plans so valuation reports are frequently accepted as is without any meaningful review by the company. Although CFOs indicated that they were largely unaware of any companies being challenged on 409A issues, it should be noted that beginning in February 2010, the IRS began randomly auditing 6,000 companies on employment tax issues in connection with 409A compliance. It is also believed that this number is expected to grow, as an increasing number of companies have received Information Document Requests requesting detailed information about plans subject to 409A.

In addition to the risks of an IRS challenge, startup companies are subject to the risk that venture capital (“VC”) firms may reject their prior 409A valuation work, particularly if the work was performed internally or from a firm that lacks expertise in valuing startup companies, thus potentially delaying or jeopardizing a financing opportunity. Many VC firms restrict their portfolio companies to only engage companies contained on a list of reputable valuation firms. There has even been evidence that VC firms have required portfolio companies to re-do prior 409A valuations, as many VC firms are risk adverse with regards to compliance issues.

Specific Valuation Challenges for Startups and Highly Leveraged Companies

Correctly ascribing value to a startup or highly leveraged company can sometimes be difficult. In addition to being subject to a constantly evolving business model and environment, these companies are subject to the following additional valuation challenges:

  • Volatility of results – Early-stage companies are subject to rapid changes in outlook that may materially influence the value of the company. 409A guidelines indicate that a valuation is applicable for a 12-month period or until a material event (e.g., a subsequent round of financing, new product launch, etc.). If management suspects that a material event has occurred and it intends to enter into a new deferred compensation plan based upon a prior valuation, it may be at risk of incurring significant penalties if the value at such time is deemed to have increased. For highly leveraged companies, including portfolio companies of buyout funds, it is not uncommon for a majority of the capital structure to be comprised of debt. A 5% increase or decrease in the enterprise value of a company could fairly easily result in a change in equity value of 50% or more. Therefore, it is important to have a well-supported and reasonable basis for the enterprise value conclusion.
  • Complex capital structures – Startup companies are typically funded through successive rounds of financing, with each round ranking senior to the previous round(s). Consequently, it is not uncommon for startups to feature capital structures consisting of common stock and as many as four or five classes of preferred stock, each with different liquidation preferences and participation rights. Since 409A valuations are typically performed at the common stock level, it is important that the valuation considers the separate values attributable to each tranche of securities.
  • Exit scenario considerations – Companies anticipating a change-of-control event within 90 days or initial public offering (“IPO”) within 180 days should be aware of the additional 409A risk since safe harbor provisions do not apply in such an event. If an exit scenario is likely during such a time period, it is critical that a valuation is performed that contemplates such an event and is performed by a professional with experience determining values used in transactions.

Acceptable Valuation Methodologies – What Makes a Valuation “Reasonable”?

  • The 409A guidelines indicate that the following factors to be considered under a reasonable valuation method include, as applicable:
  • The fair market value of tangible and intangible assets of the company
  • The present value of future cash flows
  • The market value of stock or equity interests in comparable companies
  • Recent arm’s length transactions involving the sale or transfer of such stock or equity interests
  • Other relevant factors such as control premiums or discounts for lack of marketability

In general, the IRS encourages the consideration of a form of the Income Approach, the Market Approach, and the Asset Approach in determining the value for 409A purposes. Therefore, a robust analysis should consider the three approaches and be supported by reasonable assumptions in determining the enterprise value of the company (the total value, inclusive of both debt and equity).

Once the total enterprise value is determined, it is necessary to allocate value to the common equity. Common equity represents a residual interest typically derived by subtracting the values of all securities senior to the common equity in the capital structure. This is known as the current value method, which is based on the assumption that liquidation occurs as of the valuation date and the proceeds are distributed based upon each security’s liquidation and participation rights. However, most companies operate as going concerns with no imminent liquidation event, and alternative methods of allocating value to the common equity interests are necessary. Moreover, a situation where the enterprise value is below the liquidation claims of the securities senior to common equity (e.g., an enterprise value of $30 million with liquidation preferences on the preferred stock of $40 million) would indicate de minimis value for the common equity. The current value method fails to adequately consider the optionality of the common equity (i.e., the “upside potential”).

In response to this, the American Institute of Certified Public Accountants (“AICPA”) published a practice aid, Valuation of Privately-Held Company Securities as Compensation, which presents two alternative methods to allocate value: the Probability-Weighted Expected Return Method (“PWERM”) and the Option-Pricing Method (“OPM”). The PWERM is a valuation approach based upon various future outcomes, such as an IPO or continued operation, and the probability-weighted present values associated with such outcomes. The OPM treats common equity as a call option based on the optionality over and above the value of all claims senior in the capital structure.

A 409A valuation should consider a variety of valuation approaches in determining the total enterprise value, and then appropriately allocate value based upon the unique capital structure of the subject company using the methods described above. Companies should be aware of the risks associated with relying upon a valuation based upon an overly-“simplistic” valuation approach, including those that rely upon rules of thumb and inadequately supported assumptions.

Secondary Market Considerations

The secondary market for shares in privately held companies has grown significantly and poses unique issues for 409A valuations. SecondMarket, an intermediary for secondary sales of interests in startups, reported total year-to-date transaction volume of $250 million through the third quarter of 2010, which represents 2.5 times 2009 volume and five times 2008 volume.2 This growth is partially attributable to the lack of IPO and merger and acquisition activity as employee shareholders seek another method to obtain liquidity.

Although the majority of current transaction activity in the secondary market is confined to the largest VC-backed companies (e.g., Facebook, LinkedIn, Twitter, etc.), the secondary market is experiencing an increase in the number of companies whose shares are being transacted as it becomes more liquid and investor demand remains strong. In light of this, companies should beware of secondary transactions and understand any inconsistencies in relation to the 409A valuation. For companies in which secondary market sales have occurred, the following factors should be considered:

  • How recently the transaction was completed – Given that startups are subject to significant changes in short periods of time and may lose or gain investor favor quickly, the timeliness of secondary market transactions matters when drawing comparisons.
  • What the seller’s motivations are – Many sellers in the secondary market are employee shareholders. Personal motivations (e.g., financial hardship) may result in a seller seeking immediate liquidity at the cost of a heavy discount to the intrinsic value.
  • How comparable the transacted securities are to the subject security – 409A valuations are typically performed based on the value of the company’s common stock. However, the secondary market may include sales of various other securities, including preferred stock with varying liquidation preferences, participation features, and voting rights.

Overall, the secondary market for private company stock has not reached full efficiency and it could be argued that the values implied by these transactions are not always reliable indicators of fair market value. However, each transaction is unique and warrants further consideration.

Conclusion

Overall, there are several critical issues that company management must consider when evaluating 409A valuation procedures. A robust, independent valuation from a qualified expert will help companies ensure that these issues have been addressed and the safe harbor principles have been upheld, thus mitigating the risk of an IRS challenge.