Although 409A does not exclusively affect private equity-backed firms, Axiom Valuation's experience suggests that the largest percentage of firms that are adversely affected by 409A regulations are firms that are venture or private equity backed. Managements of these firms often establish exercise prices that are below fair value of its common giving rise to payment of additional taxes as well as penalties. To remove the likelihood of this happening, managements are turning to Axiom Valuation to help them determine the fair value of their common and hence the exercise price for their option grants.
Ordinarily determining the fair value of a private firm's equity, while complex, is well understood and reasonably straight forward to do. When the firms in question are venture backed or early stage, this is not generally the case. There are two reasons for the complexity. The first relates to the complicated capital structures these firms often have. This includes several rounds of preferred stock convertible to common. Each preferred round may have different characteristics related to liquidation preference, drag-along rights as well as embedded call options which allow management to buy out the preferred holders according to a specified schedule of prices at varying points in time. In addition, convertible preferred often have warrants attached which represent potential dilution of common and a lower common stock value. In short, the firm's basic equity pie- enterprise value less the market value of debt- has multiple claimants with various rights. It is the valuing of these rights that raises the level of difficulty.
The second reason relates to developing a uniform methodology that is acceptable to the IRS and the SEC that segments out the value of the common from the value of the other equity components. For businesses that are making money, the determination of common stock value is somewhat less difficult than for an emerging firm that is losing money and is expected to do so for some period of time. In this instance, traditional stock valuation models are less useful and another set of methods is required. Both FASB and the AICPA indicate that contingent claims modeling is appropriate in these circumstances and Axiom Valuation is a recognized expert in applying contingent claims modeling to 409A and related situations.