Focus on IRS Section 409a
Not All Classes of Equity Were Created Equal
IRS Section 409A requires that companies issuing stock options (or stock appreciation rights) determine the fair market value of the underlying shares at each grant date. Compliance with Section 409A may be particularly troublesome for start-up companies in various stages of corporate development. Such companies frequently grant options, and are often capitalized with several classes of preferred and common equity securities with differing associated economic and control rights.
While the presence of several classes of equity can prove vexing when valuing the individual securities, valuation professionals have developed methods to tackle these problems, three of which are discussed in the AICPA Practice Aid: Valuation of Privately-Held-Company Equity Securities Issued as Compensation.
Due to the substantial risk that is often involved in investing in early-stage startup companies, investors often demand higher returns and greater corporate influence. As a startup company matures, capital needs tend to increase while the perceived risk often decreases, leading to multiple rounds of financing (generally structured as preferred equity). A thorough understanding of the different rights associated with the various classes of equity is necessary to properly allocate a company's value between the different equity securities.
The rights pertaining to different classes of preferred or common equity can be generally categorized as economic rights or control rights. Basically, economic rights are intended to provide economic protections and preferences relative to lower classes of equity, while control rights are designed to provide discretion and influence with respect to significant corporate decisions. Typical economic rights include preferred dividends, liquidation preferences, mandatory redemption rights, and conversion rights, among others. Typical control rights include voting rights, veto rights, board composition, and first refusal rights, among others.