section 409a real world recommendations from experts in the field

Section 409A Section 409A

Real World Recommendations from Real World Recommendations from Experts in the FieldExperts in the Field

AgendaAgenda

IntroductionsIntroductions General Scope of IRC 409AGeneral Scope of IRC 409A 409A Compliance & Equity Compensation409A Compliance & Equity Compensation Valuation MethodologyValuation Methodology Frequently Asked 409A QuestionsFrequently Asked 409A Questions Audience QuestionsAudience Questions

IntroductionsIntroductions Elliot Williams (Moderator)Elliot Williams (Moderator)

PresidentPresidentMirus Capital AdvisorsMirus Capital Advisors Elliot Williams joined Mirus in 1991, has been a Partner since 1997, and Elliot Williams joined Mirus in 1991, has been a Partner since 1997, and

has served as President of the firm since 2000. Mr. Williams has worked has served as President of the firm since 2000. Mr. Williams has worked on more than 60 advisory engagements for clients – negotiating, on more than 60 advisory engagements for clients – negotiating, structuring, valuing and closing mergers, acquisitions, and financings. structuring, valuing and closing mergers, acquisitions, and financings. An expert on the Business Services Industry, over his career Mr. An expert on the Business Services Industry, over his career Mr. Williams has managed engagements in business process outsourcing, Williams has managed engagements in business process outsourcing, hosting, systems integration, staff augmentation, and trade show hosting, systems integration, staff augmentation, and trade show management. He has also represented clients in other industries management. He has also represented clients in other industries including software, telecommunications, packaging and specialty including software, telecommunications, packaging and specialty coatings. Mr. Williams currently serves as the President of the coatings. Mr. Williams currently serves as the President of the Association for Corporate Growth, as an advisor to the boards of Association for Corporate Growth, as an advisor to the boards of several entrepreneurial companies, and as an active member of the several entrepreneurial companies, and as an active member of the Boston Chamber of Commerce and the Alliance of Merger and Boston Chamber of Commerce and the Alliance of Merger and Acquisition Advisors.Acquisition Advisors.

Mr. Williams earned a B.S. in Business Administration from Babson Mr. Williams earned a B.S. in Business Administration from Babson College and holds Series 7 and 63 NASD certifications. College and holds Series 7 and 63 NASD certifications.

IntroductionsIntroductions Bas van der Brugge (Finance/Valuations) Bas van der Brugge (Finance/Valuations)

Senior AssociateSenior AssociateMirus Capital AdvisorsMirus Capital Advisors Bas van der Brugge is a Senior Associate with Mirus, where he Bas van der Brugge is a Senior Associate with Mirus, where he

conducts Section 409As for clients. Additionally, he has participated in conducts Section 409As for clients. Additionally, he has participated in over a dozen M&A engagements at Mirus. Prior to joining Mirus, Bas over a dozen M&A engagements at Mirus. Prior to joining Mirus, Bas was an associate and member of the Corporate Finance and Strategy was an associate and member of the Corporate Finance and Strategy Practice at McKinsey & Company in Amsterdam. While at McKinsey, Practice at McKinsey & Company in Amsterdam. While at McKinsey, Bas worked with the senior management of leading European and Asian Bas worked with the senior management of leading European and Asian companies on market analyses, company and project valuations, and to companies on market analyses, company and project valuations, and to advise and structure joint ventures and strategic alliances for advise and structure joint ventures and strategic alliances for acquisitions and divestitures. He has worked extensively in the software, acquisitions and divestitures. He has worked extensively in the software, services, telecommunications, and transportation industries. services, telecommunications, and transportation industries.

Bas graduated with a Master of Science degree in Financial Bas graduated with a Master of Science degree in Financial Econometrics from Erasmus University in Rotterdam, the Netherlands. Econometrics from Erasmus University in Rotterdam, the Netherlands. In addition to being a CFA charter holder, he holds Series 7 and 63 In addition to being a CFA charter holder, he holds Series 7 and 63 certifications from the NASD. certifications from the NASD.

IntroductionsIntroductions Andrew Liazos (Legal)Andrew Liazos (Legal)

PartnerPartnerMcDermott Will & Emery LLP - BostonMcDermott Will & Emery LLP - Boston Andrew Liazos heads the Firm’s executive compensation practice in the Andrew Liazos heads the Firm’s executive compensation practice in the

law firm of McDermott Will & Emery LLP.law firm of McDermott Will & Emery LLP. Andrew is ranked as a leading executive compensation and employee Andrew is ranked as a leading executive compensation and employee

benefits lawyer by Chambers USA – America’s Leading Lawyers for benefits lawyer by Chambers USA – America’s Leading Lawyers for Business. Business.

Andrew is a faculty member of the American Law Institute-American Bar Andrew is a faculty member of the American Law Institute-American Bar Association, a John S. Nolan Fellow of the ABA’s Section of Taxation Association, a John S. Nolan Fellow of the ABA’s Section of Taxation and a frequent commenter on IRS proposed regulations and guidance.and a frequent commenter on IRS proposed regulations and guidance.

Mr. Liazos is a graduate of the University of Massachusetts and Suffolk Mr. Liazos is a graduate of the University of Massachusetts and Suffolk University Law School. University Law School.

IntroductionsIntroductions Alex Lifson (Tax & Accounting)Alex Lifson (Tax & Accounting)

DirectorDirectorDeloitte Tax LLPDeloitte Tax LLP Alex Lifson is a Director in the Global Employment Services Alex Lifson is a Director in the Global Employment Services

practice at Deloitte. Alex assists clients with numerous issues practice at Deloitte. Alex assists clients with numerous issues related to executive compensation and employee benefits. His related to executive compensation and employee benefits. His practice is focused on designing and implementing equity practice is focused on designing and implementing equity compensation strategies, executive compensation issues in compensation strategies, executive compensation issues in mergers and acquisitions, various retirement and incentive mergers and acquisitions, various retirement and incentive programs, deferred compensation arrangements and programs, deferred compensation arrangements and performance based compensation. performance based compensation.

Mr. Lifson holds a B.A. in Economics from Bates College, an Mr. Lifson holds a B.A. in Economics from Bates College, an M.B.A. from Boston University and an M.S. in Taxation from M.B.A. from Boston University and an M.S. in Taxation from Northeastern University. Northeastern University.

AgendaAgenda

IntroductionsIntroductions General Scope of IRC 409AGeneral Scope of IRC 409A 409A Compliance and Equity 409A Compliance and Equity

CompensationCompensation Valuation MethodologyValuation Methodology Frequently Asked 409A QuestionsFrequently Asked 409A Questions Audience QuestionsAudience Questions

What is IRC 409A?What is IRC 409A? Congress enacted 409A as part of the American Jobs Congress enacted 409A as part of the American Jobs

Creation Act of 2004 in response to perceived abusive Creation Act of 2004 in response to perceived abusive compensation practicescompensation practices

IRC 409A applies to “non-qualified deferred IRC 409A applies to “non-qualified deferred compensation” (NQDC) compensation” (NQDC) Restricting the timing of deferral electionsRestricting the timing of deferral elections Limiting permissible payment eventsLimiting permissible payment events Restricting changes to time and form of paymentsRestricting changes to time and form of payments Restricting certain funding vehiclesRestricting certain funding vehicles

Deferred compensation results in current income and is Deferred compensation results in current income and is subject to an excise tax, when it is earned or becomes subject to an excise tax, when it is earned or becomes vested, if the plan does not meet specific requirementsvested, if the plan does not meet specific requirements

What is IRC 409A?What is IRC 409A?

Applies to employees, directors and “other Applies to employees, directors and “other service providers”service providers”

Applies in addition to 451 constructive Applies in addition to 451 constructive receipt rulesreceipt rules

409A contains very specific rules 409A contains very specific rules governing the timing of deferrals, timing of governing the timing of deferrals, timing of distributions, funding methods and various distributions, funding methods and various other aspects of deferred compensation other aspects of deferred compensation

How does the IRS define deferred How does the IRS define deferred compensation?compensation?

Legally binding right to compensation received Legally binding right to compensation received in one taxable year, with actual or constructive in one taxable year, with actual or constructive receipt of income in anotherreceipt of income in another

Legally binding right Legally binding right does not existdoes not exist if Company if Company has discretion to reduce compensation after has discretion to reduce compensation after services are performedservices are performed

Legally binding right Legally binding right does existdoes exist if: if: Discretion is available only on a conditionDiscretion is available only on a condition Lacks substantive significanceLacks substantive significance

What plans are subject to 409A?What plans are subject to 409A?

Definition is very broad and includes:Definition is very broad and includes: Elective deferred compensationElective deferred compensation Non-elective arrangements (e.g. SERPs)Non-elective arrangements (e.g. SERPs) 457 (f) arrangements457 (f) arrangements Certain types of severanceCertain types of severance Certain plans outside the United StatesCertain plans outside the United States

What plans are subject to 409A?What plans are subject to 409A?

Example:Example: Consultant prepares PowerPoint presentation for Consultant prepares PowerPoint presentation for

annual bonusannual bonus Performance period for annual bonus is the Performance period for annual bonus is the

calendar yearcalendar year Compensation Committee “approves” plan designCompensation Committee “approves” plan design Bonus plan document is drafted but is not formally Bonus plan document is drafted but is not formally

adoptedadopted No payment date is specified for the bonusNo payment date is specified for the bonus Payment is made six months after the end of the Payment is made six months after the end of the

calendar yearcalendar year Key issue: “Legally binding right”Key issue: “Legally binding right”

What are the exceptions to 409A?What are the exceptions to 409A?

Customary payroll timingCustomary payroll timing Short term deferralsShort term deferrals Certain equity compensationCertain equity compensation

Non-discounted optionsNon-discounted options Restricted stockRestricted stock Stock Appreciation Rights (SARs)Stock Appreciation Rights (SARs)

Restricted propertyRestricted property Arrangements between partners and Arrangements between partners and

partnershipspartnerships Separation pay arrangementsSeparation pay arrangements

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What are the penalties for non-What are the penalties for non-compliance?compliance?

If there is a violation, affected service providers owe:If there is a violation, affected service providers owe: Current tax on deferrals for current year and all prior years (to Current tax on deferrals for current year and all prior years (to

the extent not subject to a substantial risk of forfeiture)the extent not subject to a substantial risk of forfeiture) Interest at underpayment rate + 1% from original deferral dateInterest at underpayment rate + 1% from original deferral date Additional tax of 20% of the taxable compensationAdditional tax of 20% of the taxable compensation

If plan is not drafted correctly, all plan participants could If plan is not drafted correctly, all plan participants could be “affected” and all post-2004 deferrals taxablebe “affected” and all post-2004 deferrals taxable

Date to amend plans for 409A compliance will likely be Date to amend plans for 409A compliance will likely be extended beyond 12/31/06extended beyond 12/31/06

Timing of service recipient’s deduction not affectedTiming of service recipient’s deduction not affected Few employers providing tax gross-up paymentsFew employers providing tax gross-up payments

How does 409A affect Stock Options How does 409A affect Stock Options and SARs?and SARs?

Non-discounted options not subject to Section Non-discounted options not subject to Section 409A409A

Similar treatment now extended to all SARsSimilar treatment now extended to all SARs private and public companiesprivate and public companies cash and stock settled arrangementscash and stock settled arrangements

Exercise price may not be less than the “value” Exercise price may not be less than the “value” of the “service recipient stock” on the “grant of the “service recipient stock” on the “grant date”date”

Tax on vesting for discounted stock options & Tax on vesting for discounted stock options & SARSSARS

Concepts apply to LLCs and partnershipsConcepts apply to LLCs and partnerships

What is the Grant Date?What is the Grant Date?

Grant date critical for measuring compliance Grant date critical for measuring compliance Terms of the grant must be “irrevocably Terms of the grant must be “irrevocably

established”established” What about letter agreements to new hires?What about letter agreements to new hires?

Compare to FASB Position under FAS 123(R)Compare to FASB Position under FAS 123(R) Board approval date is the grant date if:Board approval date is the grant date if:

employee cannot negotiate key terms and conditions employee cannot negotiate key terms and conditions between the approval date and notification date andbetween the approval date and notification date and

terms are communicated within a “reasonably short period terms are communicated within a “reasonably short period of time” after the approval dateof time” after the approval date

Need for internal controls on granting practicesNeed for internal controls on granting practices

What is the Grant Date?What is the Grant Date?

A “modification” triggers the grant of a new stock rightA “modification” triggers the grant of a new stock right Does a new stock right comply with 409A on re-grant?Does a new stock right comply with 409A on re-grant?

Option repricingsOption repricings Exception for M&A option exchangesException for M&A option exchanges

An extension or renewal is treated as an additional An extension or renewal is treated as an additional deferral feature from grant date, so 409A appliesdeferral feature from grant date, so 409A applies

Limited exception under proposed regulations allows Limited exception under proposed regulations allows for extended post-termination exercise period until for extended post-termination exercise period until end of calendar year or, if laterend of calendar year or, if later two and one-half monthstwo and one-half months

What is Service Recipient What is Service Recipient Stock?Stock?

Only “service recipient stock” qualifies for Only “service recipient stock” qualifies for exceptionexception

Covered entities:Covered entities: 50% or more subsidiaries50% or more subsidiaries 20% or more joint ventures with legitimate business 20% or more joint ventures with legitimate business

criteriacriteria Covers publicly traded stock or, if none, the most Covers publicly traded stock or, if none, the most

valuable form of common stock in the aggregatevaluable form of common stock in the aggregate Issues under the proposed regulations:Issues under the proposed regulations:

preferred stock ineligiblepreferred stock ineligible multiple classes of common stockmultiple classes of common stock non-publicly traded subsidiariesnon-publicly traded subsidiaries

What is the Value for a Private What is the Value for a Private Company?Company?

Value determined "by the reasonable application Value determined "by the reasonable application of a reasonable valuation method" – what does of a reasonable valuation method" – what does that mean?that mean?

Unreasonable to use Unreasonable to use a previously calculated value that fails to reflect all a previously calculated value that fails to reflect all

material information, or material information, or a calculation that is more than 12 months olda calculation that is more than 12 months old

Two primary safe harborsTwo primary safe harbors Written valuation report for illiquid stock by person with Written valuation report for illiquid stock by person with

significant knowledge and experience - unavailable if: significant knowledge and experience - unavailable if: company more than 10 years oldcompany more than 10 years old liquidity event is within 12 months after the option grant or liquidity event is within 12 months after the option grant or put/call rights on stockput/call rights on stock

Independent AppraisalIndependent Appraisal

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What guidelines has the IRS given What guidelines has the IRS given for 409A valuations? for 409A valuations?

““Reasonable method, reasonably and Reasonable method, reasonably and consistently applied”consistently applied” the value of the value of tangible and intangible assetstangible and intangible assets of the of the

corporation;corporation; the the present value of future cash-flowspresent value of future cash-flows of the of the

corporation;corporation; the the market valuemarket value of stock or equity interests in similar of stock or equity interests in similar

corporations and other entities engaged in businesses corporations and other entities engaged in businesses substantially similar to those engaged by the substantially similar to those engaged by the corporation; andcorporation; and

other other relevant factorsrelevant factors, such as control premiums or , such as control premiums or lack of marketabilitylack of marketability

How is a typical enterprise valuation How is a typical enterprise valuation different from a 409A valuation? different from a 409A valuation?

Determine Total Enterprise Values (TEV) using various methods

Model capital structure (liquidation preferences, conversions, options, etc).

Determine common stock valuation using allocation method

Specific to 409A (and other option plan related valuations)

What does a full valuation entail? What does a full valuation entail?

Market Approach Public markets

M&A transactions

Private placements

Asset Approach Liquidation value

Income Approach Discounted cash flows

(Embedded) options

Scenario analysis

Company Specific Prior equity events

Approach Method

Replacement cost

Other relevant factors

-

5

10

15

20

25

30

35

40

- 10 20 30 40 50 60 70 80 90 100

Common

Options

Series A

Series B

What complexities arise due to the What complexities arise due to the capital structure?capital structure?

Series BLiq. Pref.

Series ALiq. Pref.

OptionsExercised

Series ACaps

Series BCaps

Series AConverts

Series BConverts

Equity value ($ MM)

Proceeds ($ MM)

What are the different value What are the different value allocation methods? allocation methods?

Current Method Current Method Value common as if a liquidity event occurs todayValue common as if a liquidity event occurs today Apparently widely used, but only appropriate in limited Apparently widely used, but only appropriate in limited

circumstancescircumstances Option MethodOption Method

Either Black & Scholes or binomial treesEither Black & Scholes or binomial trees Depends on some critical inputs such as volatility and Depends on some critical inputs such as volatility and

exit horizonexit horizon Probability Weighted Expected ReturnProbability Weighted Expected Return

Valuation analysis based on various exit scenarios Valuation analysis based on various exit scenarios (IPO, trade sale, liquidation)(IPO, trade sale, liquidation)

Highly dependent on a handful of assumptionsHighly dependent on a handful of assumptions

How can you account for the How can you account for the evolution of value? evolution of value?

Scenario 3$ 0 MM

Scenario 2$ 50 MM

Scenario 1$ 150 MM

Year 1$ 40 MM

10%

40%

30%

60%

10%

Year 2$ 75 MM

50%

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Frequently Asked QuestionsFrequently Asked Questions

What 409A issues arise in M&A What 409A issues arise in M&A transactions?transactions?


How can IRC 409A impact my ability How can IRC 409A impact my ability to go public?to go public?


Can I do the section 409A valuation Can I do the section 409A valuation myself?myself?


How does IRC 409A relate to How does IRC 409A relate to FAS123R? FAS123R?

AgendaAgenda

IntroductionsIntroductions General Scope of IRC 409AGeneral Scope of IRC 409A Compliance with 409ACompliance with 409A Valuation MethodologyValuation Methodology Frequently Asked 409A QuestionsFrequently Asked 409A Questions Audience QuestionsAudience Questions

Audience Questions Audience Questions

Thank you Thank you This presentation can be downloaded at This presentation can be downloaded at

http://www.merger.com/409awebinarhttp://www.merger.com/409awebinar Presenter contact information:Presenter contact information:

Elliot Williams, Mirus Capital AdvisorsElliot Williams, Mirus Capital Advisors [email protected]@merger.com; 781-418-5932; 781-418-5932

Bas van der Brugge, Mirus Capital AdvisorsBas van der Brugge, Mirus Capital Advisors [email protected]@merger.com; 781-418-5941; 781-418-5941

Alexander G. Lifson, DeloitteAlexander G. Lifson, Deloitte [email protected]@deloitte.com; ; 617-437-2546617-437-2546

Andrew C. Liazos, McDermott Will & EmeryAndrew C. Liazos, McDermott Will & Emery [email protected]@mwe.com; 617-535-4038; 617-535-4038

section 409a real world recommendations from experts in the field

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