Section 409A was added to the Internal Revenue Code
("IRC") by the Internal Revenue Service ("IRS") in October
2004 as Section 885 of the American Jobs Creation Act of 2004, and it went into
effect on December 31, 2004.
IRC The IRS enacted Section 409A in response to the Enron
Corporation's 2001 scandal, which involved several compensation-related
accounting frauds. Among Enron's fraudulent activities was the awarding of
large stock options and deferred compensation to key executives. Prior to
Enron's bankruptcy in 2001, certain key executives accelerated the vesting of
their stock options, exercised them, and sold the underlying stock at all-time
highs. These actions protected a few individuals' interests while costing the
remaining Enron employees a large portion of their retirement savings. As a
result of Enron's nefarious actions, the IRS added Section 409a Valuation
to the IRC on January 1, 2005, and changed a number of rules governing deferred
compensation plans, including the regulations governing a company's executives'
ability to choose when to receive such benefits.
According to IRC Section 409A rules, any private company
that provides "equity-based compensation" to its employees in the
form of stock options, stock appreciation rights, warrants, restricted stocks,
restricted stock units, performance stock units, or other must first determine
the Fair Market Value ("FMV") of its stock4. The valuation date
should be as close as possible to the grant date5 of the equity-based
compensation award. Furthermore, the valuation must be updated at least once a
year, or whenever a material event occurs (whichever comes first)." New
equity financings; an acquisition offer by another company; certain instances
of secondary sales of common stock; and significant changes (good or bad) to a
company's financial outlook are examples of "material events." A
company's credibility
STEP 1 - Determine the Subject
Company's Enterprise Value
There are three commonly used approaches for determining a
company's Enterprise Value (detailed below together with methodological
examples, not an exhaustive list, of each approach).
1. Market Strategy:
Guideline Public Corporations The method value is calculated
by comparing several publicly traded companies of similar size and industry -
Comparable Set. The selected multiple of this Comparable Set, such as EBITDA,
Revenue, Net Income, and so on, is then used to determine and calculate the
Enterprise Value of the subject company.
2. Income Strategy:
This method involves determining the value of the subject
company based on specific benefit streams, such as earnings or cashflows. The
Discounted Cash Flow ("DCF") and Capitalization of Earnings
("COE") methods are commonly used in 409A valuations.
3. Asset/Cost Analysis:
This is a less common valuation method in which the value is
determined by the difference between the fair market value of balance sheet
assets and liabilities (often including non-balance sheet items in the value
determination). The Adjusted Net Asset Value ("NAV") method is the
primary method used in the asset approach. This method is frequently costly
because it necessitates valuations of individual balance sheet items and
frequently results in the lowest value determined for a going concern business
(over that of the income and market approaches).
STEP 2 – Calculate Equity Value of the Subject Company
Following the determination of the Enterprise Value, the
next step is to calculate the Equity Value of the subject company.
STEP 3 - Allocate Equity Value to Each Capital Structure Class of the Subject Company - Equity Allocation
A privately held company's capital structure may include
more than one type of security, such as common stock, preferred stock, options,
and warrants. This multi-class equity composition is referred to as a
"Complex Capital Structure." Such complex capital structures
necessitate allocating equity value to each class of the company's capital
structure.
1. Option Pricing Model (OPM):
This method considers common stock and preferred stock as
call options (to purchase at a specific price) on the equity value, with
exercise prices based on the preferred stock's liquidation preferences10. The
base price is required to build the incremental value at the breakpoints.
Appraisers commonly employ this method in situations where future liquidity
events are difficult to forecast (such as an IPO, merger and/or acquisition
transaction, or entity dissolution). The Black-Scholes Option Pricing Model is
the most commonly used OPM.
2. PWERM (Probability Weighted Expected Returns Method):
This method of allocation bases share value on the
probability-weighted present value of expected future investment returns,
taking into account each of the enterprise's possible future outcomes as well
as the rights of each share class. An IPO, merger and/or acquisition,
divestiture, or continuation as a private company are all examples of
"future outcomes." PWERM estimates the future and present value
ranges for each future outcome and applies a probability factor11 to each
outcome as of the valuation date.
3. CVM (Current Value Method):
The CVM allocation method estimates equity value on a
controlling basis, assuming an immediate sale or liquidation of the enterprise.
The allocation is then made based on the liquidation preferences or conversion
values of the series, whichever is greater.
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