409A Valuations: Understanding The Impact On Stock-Based Compensation

An Internal Revenue Code (IRC) 409A valuation is an independent appraisal of a private company's stock's fair market value (FMV). Private companies often obtain these reports to gather the information needed to ensure they grant stock options that have a strike price equal to the fair market value of the common stock at the time of the grant. The board of directors is typically tasked with determining the fair market value of the company's common stock, and thus the exercise price, based on all the facts available at the time the awards are granted. The most recently available 409A valuation report often carries the most weight for making this determination. Private companies that grant stock options and other equity awards to employees typically get a 409A valuation:

• At least annually as part of granting stock options and other equity awards
• After raising a round of venture financing
• When approaching an IPO, merger, or acquisition

Because annual 409A valuations are required for tax purposes, companies must obtain a new 409A valuation at least once a year or more frequently if a material event occurs. Companies also use the FMV of their common stock obtained from the 409A in the accounting for stock-based compensation expense under Accounting Standards Codification 718 – Compensation-Stock Compensation (ASC 718).

As the public stock market ebbs and flows, private company valuations often mirror these trends. In periods prior to 2022, many private company stock prices had been trending upward. However, in 2022 and 2023, many well-known private companies cut their internal valuations as a direct result of declines in their public company peers, among other factors. This often led to questions about how to value stock awards issued in between valuation dates for accounting purposes and the impact on stock-based compensation.

The Ripple Effect of Market Fluctuations on 409A Valuations

The stock market often serves as a barometer of economic health, and its fluctuations have a domino effect on various sectors, particularly in technology.

When the stock market faces a downturn, it's not uncommon for private company valuations, especially those in tech, to follow suit. This trend is partly due to investor sentiment and market dynamics, which often view tech companies as high-growth yet volatile investments.

The Upward Trend: Opportunities

When valuations increase, stock options become more valuable, allowing companies to leverage them for employee motivation.

For example, suppose a company has one valuation dated Dec. 31, 2023, in which the value of the stock was $1.50 per share, and another dated June 30, 2024, in which the value of the stock was $2.25 per share. The company granted 500,000 options of its stock to employees on March 1, 2024. For the purposes of setting an exercise price, the company would look to the prior 409A valuation and likely would use $1.50 as the exercise price.

However, for financial reporting purposes or recording stock-based compensation expense, the company has two options: linear interpolation or hockey stick interpolation.

Linear Interpolation

In a linear interpolation, the company looks at whether any significant events occurred during the interim period between the last valuation and the stock grant date. These significant events can include material changes in:

• Enterprise milestones, such as achieving proof of concept, establishing strategic relationships, obtaining regulatory approval, etc.
• Management forecasts
• Competence of the management team
• Existing proprietary technologies, products, or services
• Workforce skills
• State of the industry or economy
• Valuation assumptions used in the last valuation

If the company determines no significant events occurred in the interim between the two 409A valuations that would cause a material change in the FMV of the company's common stock, the most common method is to straight-line, or interpolate, the common stock value between the two valuations and use that value for purposes of calculating its fair value for expense purposes under ASC 718.

Hockey Stick Interpolation

In a hockey stick interpolation, the company does identify significant events between the two valuation dates. Now, the issue is whether that significant event happened before or after the date the options were granted.

Let's assume the same facts as above, except that the company obtained regulatory approval for a key product in May 2024. In that case, it might be reasonable to assume that there was no material change in the value of the stock between the December 2023 valuation and the March 2024 grant date, and the valuation experienced a sharp rise in May 2024 due to the regulatory approval.

On the other hand, if regulatory approval had been received before granting the stock options, management would need to develop a reasonable method for reflecting the increase in the FMV of the stock on the grant date.

Downward Adjustments: Challenges

When 409A valuations drop, there can be some disagreement amongst companies on how to account for options granted between two valuation dates, especially when the decreases are material.

Many advisors will recommend straight-lining the common stock value between the two valuations and remaining consistent with how increases in the FMV are accounted for. However, it's essential to consider whether that makes sense.

When valuations are decreasing, the same two options are available: linear interpolation or hockey stick interpolation. Consistent with the considerations noted above, when valuations are increasing or decreasing, companies should consider whether any significant events occurred during the interim period between the last valuation and the stock grant date. Did changes in management forecasts, strategic relationships, the company's financial condition, or other factors cause the value of the company's stock to drop? Did the company lose a large customer? Is the lower valuation temporary and not reflective of the actual long-term value of the stock? Careful consideration should be given to any material changes in the business before deciding whether to proceed with a straight-line downward approach or take an alternative approach. In addition, if a significant event did occur, it may impact the date on which management determines the decline started or ended.

For example, the loss of a significant customer or a significant decline in the public company stock market occurring during a certain time period may drive the conclusion as to when the company's stock price also started to decline.

When the value of the underlying stock decreases, the exercise price may be higher than the stock's current valuation, a situation commonly referred to as options being "underwater."

Employees who exercise underwater options receive shares worth less than the price they paid for them. Having underwater options can lead to challenges in retaining top employees through granting equity-based compensation.

One potential solution is option repricing, in which the company lowers the exercise price of all existing stock options. To avoid penalties under 409A, the new exercise price of the repriced options must be at or above the fair value of the stock at the time of the repricing.

Typically, this means obtaining a new 409A valuation to set the revised, and presumably lower, exercise price for the repricing.

The accounting rules for compensation expense under ASC 718 generally treat the reduction of an exercise price as additional compensation expense. To account for this incremental benefit the employee is receiving upon a repricing, an organization typically looks at the valuation of the option immediately before and after the repricing using an option valuation method such as Black-Scholes. For more information on underwater stock options, please read our publication, CBIZ ARC's Underwater Stock Options, A CFO's Guide for Private Companies.

Navigating Stock-Based Compensation Complexities with Expertise

The fluctuating nature of 409A valuations in response to stock market trends presents both challenges and opportunities for companies in the area of stock-based compensation.

Whether your organization has 409A valuations that are increasing or decreasing, it's crucial to consider and document the impact on stock-based compensation and be prepared to make adjustments to the valuation of future and outstanding awards and the related financial reporting.