Internal Revenue Code 409(a) (“409A”) regulates nonqualified deferred compensation for federal tax purposes. 409A’s genesis was the American Jobs Creation Act of 2004 and is largely a reaction to common tax-timing abuse strategies, most notably those practiced by Enron executives prior to its bankruptcy.
Deferred equity compensation such as stock options pose a huge opportunity for cash strapped start-up companies trying to align incentives for employees with the goals of the business. However, with an exceptionally broad definition of deferred compensation and a heavy compliance burden, 409A can present a significant risk. Proper mitigation and compliance strategies help companies to accomplish business goals and reward employees without bearing undue risk.
Securing an Independent Appraisal
One of three safe-harbor valuation methodologies provided by 409A (and the most commonly used) is to secure an independent appraisal. This appraisal would be performed by a qualified, third-party appraiser (typically an outside provider holding an ABV or CVA designation). Additionally, the appraisal or business valuation would value the subject interest within 12 months prior to the grant date and no material change has occurred between the valuation date and grant date. If these stipulations are met, significant burden would fall on the IRS to prove that the valuation is “grossly unreasonable.”
Valuation is a largely subjective and highly theoretical exercise. Therefore, reasonableness is less about the specific fair market value determined by the appraiser and more soundly based on the methodology applied to arrive at the conclusion. Valuation theory holds that there are three approaches: (1) the income approach; (2) the market approach; and (3) the asset approach. These approaches can be further stratified into methods. An appraisal and accompanying valuation report should consider all approaches and methods, but given the circumstances that give often rise to a 409A valuation, many reflect the backsolve method.
The Backsolve Method
Before diving into the backsolve method, it is important to understand the concept of allocating equity value across various classes using an option pricing model (“OPM”). An OPM is a mathematical formula to calculate the theoretical value of derivative agreements such as call options. By setting up a series of OPMs with various strike prices, we can treat multiple equity classes as call options across ranges of proceeds. This allows us to establish a model of the relationship between the value of aggregate equity and each class of equity.
The backsolve method comes into play when there is a recent transaction for a different class of equity than the subject interest. For example, if ABC Corp. recently issued Class B Preferred Shares and the subject interest is a Class C Common Option. The appraiser can solve back to the market value of aggregate equity using the OPM and the Class B Preferred Shares transaction price. Then solve forward to fair market value of a Class C Common Option.
Relative to a discounted cash flow (“DCF”) method, the backsolve method presents a number of advantages. The backsolve method is based on pricing observed in an arm’s length transaction while a DCF method employs projections based on opaque market observations and a heavy amount of professional judgement. While the backsolve method involves a number of assumptions, those same assumptions would have to be made an add-on to the DCF method as well. A good appraiser should be able to estimate a more defensible value in a more efficient manner using the backsolve method.
The DKB Difference
In order to perform the backsolve method, an appraiser must have: (1) a proficient knowledge of advanced financial theory; (2) experience pragmatically translating lengthy agreements into financial models; and (3) a savvy leveraging of technology to do this efficiently.
DKB’s professionals have experience using the backsolve methodology to meet 409A compliance as well as other compliance purposes and the financial modeling skills required. Our flat fee structure and quick turnarounds combined with our exemplary client service make us a leader in this space. If you are interested in discussing how DKB can help you and your employees benefit from deferred compensation without exposing yourself to undue risk, please contact us.
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