Canada’s Version of a 409A Valuation
What is a 409A Valuation?
A 409A valuation entails an independent assessment of the fair market value (FMV) attributed to ordinary common shares (typically reserved for founders and employees) of a privately held company conducted at the time of issuance. A 409A valuation adheres to the guidelines and benchmarks outlined within section 409A of the Internal Revenue Service’s1 (IRS) internal revenue code (IRC).
What is IRC Section 409A?
In the aftermath of the 2001 Enron scandal, US regulators sought solutions to prevent executives from exploiting equity loopholes. As a response, the IRS introduced IRC Section 409A in 2005, with the final version taking effect in 2009. This section of the tax code aims to regulate nonqualified deferred compensation (such as stock-based compensation plans) by establishing rules on the statutory effective date, deferral elections, and timing of payments2.
Before the Enron scandal, individuals could withdraw from their deferred compensation plans earlier than they originally agreed upon while still receiving tax benefits3.
Section 409A provides a structured framework for private companies to adhere to when appraising the value of private stock. When an impartial and unrelated party conducts the valuation, a secure harbor is established, indicating that the IRS considers it inherently “reasonable,” with a few exceptions.
Failure to comply with the regulations outlined in Section 409A can result in penalties assessed by the IRS, usually affecting employees and shareholders who are left to bear the consequences of incorrectly priced equity.
What is Canada’s 409A valuation equivalent?
The Canadian equivalent to a 409A valuation is a valuation report prepared in accordance with the Canadian Institute of Chartered Business Valuators (CICBV), the leading professional body for valuators in Canada.
There are three types of valuation reports listed in the CICBV Practice Standard No. 110, and they are as follows:
- Calculation Valuation Report;
- Estimate Valuation Report; and
- Comprehensive Valuation Report.
Does Canada have Section 409A in its Income Tax Act?
Canada does not have Section 409A in its Income Tax Act. However, Section 7 of Canada’s Income Tax Act contains the framework for employee stock options.
If Canada does not have Section 409A in its Income Tax Act, do you need a 409A Valuation or a Valuation Report?
Under paragraph 110(1)(d) of Canada’s Income Tax Act, an employee may deduct one-half of the employee stock option plan (ESOP) benefit4 when calculating taxable income if:
- the employee dealt at arm’s length with the employer;
- the employee stock options entitled the employee to receive common shares; and
- the option price or exercise price is not less than the FMV of the underlying shares when the option was granted.
As such, even though a valuation at the time of grant is not explicitly required, it may be performed to ensure that the employee can benefit from the deduction at the time of exercise. The 110(1)(d) deduction allows many employees to enjoy the equivalent of capital gains treatment from a tax rate perspective on potentially large amounts of compensation. Accordingly, many compensation packages are structured, at least in part, to include this form of incentive compensation.
If an employee does not qualify for the 110(1)(d) deduction, employees who exercised their ESOP and received Canadian-controlled private corporation (CCPC) shares can receive the same one-half deduction under paragraph 110(1)(d.1) as long as the employee has held the shares for at least two years. However, the risk is that the shares may lose value during the 2-year duration. As a result, employees would rather be eligible for the 110(1)(d) deduction to minimize the risk of price depreciation during the hold period.
Common Valuation Methodologies
A common option for valuing these private company shares is using the Market approach, specifically the Option Pricing Model (OPM) Backsolve Method. This approach requires the company to have had a recent financing round. The assumption is that the latest investors paid a fair market value for their preferred shares, and valuators use this value to apply appropriate adjustments in determining the FMV of a common share at that point in time. As a result, this valuation is based on the premise that there is a relationship amongst the different classes of shares within the company, allowing for the FMV of a common share to be determined based on the preferred share pricing.
Information required by the valuator to prepare an OPM would include the following:
- Recent financial statements of the business;
- The most recent capitalization table;
- Articles of incorporation;
- Share purchase agreements; and
- An estimation of their planned liquidity event (i.e IPO or acquisitions).
Other marked-based approaches may use trading muliples obtained from comparable public companies or transactions involving comparable private companies. These multiples are then applied to the subject company’s financial data such as revenue or earnings before interest, taxes, depreciation, and amortization (EBITDA).
For companies generating sufficient positive cash flow, the valuator may select to use an income-based approach. This methodology involves quantifying the present value of future economic benefits associated with ownership of the business. Essentially, future discretionary cash flows are discounted to a present value sum using a rate of return that is appropriate for the risks associated with realizing those cash flows.
The Income Approach is commonly used to value companies that generate income available for distribution to shareholders. Common valuation methods within this approach include the Discounted Cash Flow and Capitalized Cash Flow methods.
The Capitalized Cash Flow method is preferred when the business in question has matured and when operating results have stabilized enough that it is possible to estimate a single level of maintainable cash flow that may be capitalized into perpetuity to produce a present value sum.
The Discounted Cash Flow method is preferred in situations where the business has not yet stabilized but, rather, is expected to grow rapidly. The difficulty with this approach lies in the complexity associated with developing a forecast of future operating results. One of the key issues is how much growth should be factored into the five-year forecast. If the expected growth is not possible without a cash injection, the investor may want to share in the value created (since it would not be possible without his capital injection).
The asset approach is reserved for companies that have yet to achieve commercialization and is often used for early-stage companies that have yet to raise capital.
This method involves adjusting the stated book value of a company’s assets and liabilities to their current fair market value based on their value-in-use, thereby deriving a value for the shareholders’ equity interest in the company.
A weakness of this approach is that it only considers the value of assets recognized and measured in the company’s financial statements. This may exclude other valuable internally generated intangible assets, such as industry reputation and customer relationships, contracts in progress, a skilled workforce, proprietary technologies, business systems, etc. Therefore, the Adjusted Net Asset method is not considered suitable for the purposes of valuing a profitable operating business with significant intangible value.
Once a CBV has completed the valuation analysis, they will provide an independent opinion in the form of a valuation report, which will include a range of values assessed to be fair market value.
If you’re an employer considering potential compensation packages and would want to provide your employees with the 110(1)(d) deduction, consult one of our Chartered Business Valuators (CBVs) to assist in preparing a valuation report.
1 The IRS is the revenue service for the United States Federal Government
4 Employees receiving stock options from non-CCPCs with consolidated group revenues of over $500 million will be subject to a $200,000 annual vesting limitation on the amount of stock option deduction that can be claimed under section 110(1)(d).