Understanding Valuation for Equity Compensation and Avoiding the Perils of 409A

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409 A White Paper

If you are a CEO or a CFO of a high growth startup, it is vital to understand how to value your company correctly.

Here is a quick list of questions this lunch will help you answer:

Do you offer or are you planning to offer your employees stock options? Do you know the difference between ISOs and non-ISOs? Do you understand the general valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies? Did you know that if you run afoul of the 409A rules, your employees could have an unpleasant tax surprise and that some of that responsibility could revert back to you as the employer? Do you know if and when you need to engage an outside expert to assist with a valuation?

www.thecapitalnetwork.org

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Understanding Valuation for Equity Compensation and Avoiding the Perils of 409A

  1. 1. San Francisco | Salt Lake City | Cambridge | 617.684.5510 | www.scalaranalytics.comSection 409A – Common Stock ValuationWHAT IS SECTION 409A?As part of the 2004 American Jobs Creation Act, section 409A of the IRS Code statesthat private companies should not issue stock options that are “in-the-money,” or withan exercise price that is below “fair market value.” Failure to comply with thisregulation results in a 20 percent tax penalty for the option recipient (in addition totheir applicable income tax rate) on the difference between the option’s strike price andthe fair market value of the associated security. This tax is due in the year the optionsare granted, whether or not the options are ever exercised.HOW DO YOU BEST COMPLY WITH THE REQUIREMENTS OFSECTION 409A?The IRS has instituted a safe harbor provision for this law, which provides that aformal valuation performed by an independent valuation firm will be accepted as avalid method for determining the fair market value of the company’s common stock.This avoids potential conflicts of interest and provides transparency into the fair marketvalue calculation.Once an initial valuation has been performed by an independent appraisal firm, theregulations require that the valuation opinion be updated every 12 months, or any timethere is a material change to the business.HOW IS THE FAIR MARKET VALUE OF YOUR STOCKDETERMINED?The IRS and the American Institute of Certified Public Accountants (AICPA) haveissued guidelines for valuing the common stock of privately held companies. Theseguidelines suggest that valuation experts use the market, income, and cost approachesto determine the firm’s total equity value. Equity must then be allocated among thevarious classes of stock using one of three methods: the current value method, theprobability weighted expected return method, and the option pricing method.Valuation experts discourage the practice of discounting the latest preferred roundshare price to determine the value of common stock. This approach fails to account forthe firm’s capital structure and the volatility of the firm’s value.Cost/AssetMethodSecuritiesTransactionsPublicCompsM&ACompsDCFEnterprise& EquityValuationOption Pricing(Black-Scholes)ProbabilityWeightedExpected ReturnCurrent ValueMethodFMVofCommon SharesABOUT SCALAR ANALYTICSScalar Analytics is a leading provider of independentbusiness valuation and transaction advisory servicesto growth equity companies and private equity firms.We are committed to providing accurate, independentvaluations that meet the standards of your auditorsand board members. Our Company also boasts thefastest turnaround times in the industry.Other services include ASC 718, ASC 805 and ASC820 valuations; merger and acquisition advisory;intellectual property valuations; and secondary privateequity transaction advisory.CONTACT SCALAR ANALYTICSAlicia Amaral, Managing DirectorOne Broadway, 14thFloorCambridge, MA 02142E: alicia.amaral@scalaranalytics.comO: (617) 684-5510WHAT IS THE PROCESS FOR A 409AVALUATION?Once you have retained a qualified, independentvaluation expert, the process usually involves briefinterviews with management and a review ofcompany financials and documents (executivesummary, capitalization table, articles ofincorporation, etc.). The valuation expert will use thisinformation to conduct a formal valuation and issue areport stating the conclusions.WHO USES THE VALUATION?Board members and executives use the 409Avaluation report to determine the appropriate strikeprice for stock options issued as compensation toemployees. The reports are subject to review by auditfirms for expense and tax reporting purposes. If yourcompany goes public, the SEC scrutinizes all stockoption grants to determine whether or not the exerciseprice of each grant is defensible, often referring to the409A valuations of independent appraisers. Thevaluation report may also be used in court if there is alawsuit concerning option grants and the fair marketvalue of common stock.

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