In a liquidity event everyone wants to know how big their slice of the pie is, especially when stock options have been issued to incentivize employees in an ESOP. However, their “slice” must be valued before it was ever issued. In compliance with the Internal Revenue Code Section 409a, all companies must perform a valuation of its equity.
After valuing a company’s stock, if the exercise price is beneath the Fair Market Value on the stock’s grant date, then employees can receive unfavorable tax consequences. In such case, the gain is taxed when the option is vested, not necessarily when it’s exercised, and an additional 20% non-compliance tax penalty is applied. To avoid this, the company’s management can hire a third party firm to appraise the value of the company’s equity. Not only should a firm be qualified with experience and expertise, but hiring a third party will help to build the credibility of the company’s valuation. Essentially it puts the ball in the IRS’ court, forcing them to provide strong evidence of unreasonable valuation before applying tax penalties.
A 409a valuation must be performed before the first issuance of stock options and once again every 12 months, or when an event renders the most recent valuation unreliable (a new round of financing, for example). The most appropriate valuation method depends on the company, but examples of common valuations include:
Common Stock Equivalent Method (CSEM)
This method is pretty straightforward. Here, the enterprise value is allocated to all equity classes with the assumption that they are equal, as if there were no rights or preferences. The limitation with this method is that it does not consider the occurrence of a future exit, which might give the equity a greater value, nor the possibility of the common stock’s value being reduced by liquidity preferences.
Option Pricing Method (OPM)
In this valuation method, both common and preferred stock are treated as call options on the enterprise value with the exercise price based on the preferred stock liquidation preference. If the preferred liquidation value exceeds the funds for distribution, then common stock is worthless. This valuation method is sensitive to volatility and considers many potential exit scenarios. Thus, it is best to use the OPM when future outcomes are difficult to predict and forecasts are unreliable.
Current Value Method (CVM)
This is sometimes referred to as a “waterfall analysis.” It is assumed that 100% of the company’s equity is sold. The liquidation preferences are considered and the proceeds “waterfall” down the different equity classes until common stockholders receive distributions. It is important to consider if preferred shareholders are fully-participating or non-participating, as such terms affect the liquidity of lower-claim equity classes. If a preferred stockholder is fully-participating, then they receive their initial investment and afterwards participate in the proceeds that are distributed to common shareholders on an as-converted basis; it’s simply a way to juice their return. Again, if preferred claims exceed the value of total equity, then common shares are deemed worthless. This method is often used when there is an imminent liquidation event or when the company is still at an early stage of development and does not have reason to estimate value beyond preferred shares.
Probability Weighted Expected Return Method (PWERM)
This is also a forward-looking valuation methodology. It is an expansion of the CVM where multiple potential exit scenarios are considered: a strategic merger, IPO, divestiture, or the absence of a liquidity event. To perform this valuation method, one must consider the most likely liquidity events, as well as when they are expected to happen, and the company’s equity value for each scenario. Then, the value of common stock is considered for each event, including their present values. Once probabilities are assigned for each liquidity event, then they are applied to the respective present value of common stock in order to determine the fair value of common shares. This method is difficult to apply because it’s so subjective, but it is best used when there are multiple distinct scenarios to be considered.