Stock Compensation for Start-Ups + Valuation Implications with 409(A) and 83(B)

Stock Compensation for Start-Ups + Valuation Implications with 409(A) and 83(B)

 

LUTZ BUSINESS INSIGHTS

 

Stock Compensation for Start-Ups

Stock Compensation for Start-Ups + Valuation Implications with 409(A) and 83(B)

Michael greteman, m&a manager

 

Business owners often seek to align the long-term prospects of their company with the interests of key employees and members of management. In addition to the direct sale or issuance of company shares to these employees, other mechanisms for aligning interests are available, including incentive stock options, restricted share awards, performance agreements, phantom stock plans, etc.

The world of employee stock compensation is vast and can be complicated. With that in mind, we will focus on equity incentive compensation plans common in early-stage and development-stage private businesses (start-ups).

 

Common Forms of Stock Compensation for Start-Ups

Hiring and retaining high quality employees is imperative for companies in the start-up phase. While most start-ups likely have a dedicated founder or two, the build-out of other key employees such as software engineers or experienced executives can be challenging when capital is limited and profitable operations are years away. Therefore, many employees are paid non-cash compensation in exchange for their services. Three of the most common forms of non-cash compensation used by start-up companies are stock options, restricted stock awards and stock appreciation rights.

1. Stock options

A stock option is a financial instrument that gives the holder the right, but not the obligation, to buy a share of stock at an agreed-upon price at a future date. With a stock option, the employee can share in the appreciation in value of company stock above the option exercise price. The two types of stock options are incentive stock options, which are granted only to employees, and non-qualified stock options. We will focus on non-qualified stock options granted to employees for the purposes of this discussion.

2. Restricted stock awards (RSAs)

RSAs are a form of compensation by which the employee is granted actual shares of stock in a company. While the shares are initially restricted, the restriction is gradually lifted as the shares are earned (share vesting). The vesting schedule is outlined in the grant documents and often includes a vesting cliff followed by monthly or annual vesting. RSAs are typically issued to early employees when the fair market value of common stock is very low.

3. Stock appreciation rights (SARs)

Stock appreciation rights are a form of stock compensation, without stock ownership, by which the employee compensation is linked to the appreciation in stock value. At vesting, the company can elect to pay the employee in cash or stock (less common). The main benefit of this type of compensation is the lack of dilution to the company’s existing stockholders.

 

Tax Considerations – Section 409(A)

As can be expected, there are tax consequences to both the employee (service provider) and the company (service recipient) in establishing stock compensation plans, whether in the form of corporate stock, LLC units, or partnership profits interests. Prior to the passage of the American Jobs Creation Act in 2004, the rules related to stock compensation were relatively lax. However, given the exploitation of certain stock option loopholes by well-known companies approaching bankruptcy in the early 2000s (i.e., Enron), the IRS included a much more stringent regulation known as Section 409(A) in the 2004 Act.

In a nutshell, Section 409(A) establishes a framework that limits the ability of taxpayers to defer compensation under non-qualified deferred compensation plans (NQDCP) by imposing strict requirements, which can include limitations on vesting and payments of awards. Given the breadth with which Section 409(A) was written, many other types of non-traditional compensation plans fall under its purview, including certain stock options and SARs.

If the NQDCP does not meet the Section 409(A) requirements, the taxpayer (service provider) will be immediately taxed on the non-complying deferred compensation plus interest and an additional 20% tax penalty. The granting of non-cash compensation meets the safe harbor for 409(A) treatment (i.e., is exempt) if it meets the following conditions:

  • Stock options: Exercise price of the option at grant date is greater than or equal to the fair market value of the stock at that date (in other words, not “in the money”)
  • Restricted stock awards: Generally, are not subject to Section 409(A) unless certain provisions are present
  • Stock appreciation rights: Base price for the SAR at grant date is greater than or equal to the fair market value of the stock at that date (not “in the money”)

The main takeaway relating to stock options and SARS as it pertains to Section 409(A) is that the exercise or base price at the date of grant must be greater than or equal to the fair market value of the underlying security for it to qualify as deferred compensation and thereby be non-taxable at the date of grant. Once the stock option or SAR is exercised, the difference between the fair market value at exercise and the exercise price or base price is taxed as ordinary income. In the case of a stock option, once the stock is later sold, the proceeds over the basis will be taxed as a capital gain (or loss).

 

Tax Considerations – Section 83(B)

Restricted stock awards are generally considered to be property subject to a “substantial risk of forfeiture.” While the employee will receive actual shares of stock in the company, the risk of forfeiture will be implicit until the property is earned and the employee owns it outright. If the employee does not satisfactorily provide the required services or certain milestones are not achieved, the company typically has the right to repurchase the RSA shares at a significant discount to fair market value.

The Section 83(B) provision in the tax code allows for the recipient of RSAs to, within 30 days of receipt, file the Section 83(B) election for the shares to be taxable at the grant date rather than at the vesting date(s). While it is normally preferable to defer taxes, in the context of a start-up, if the company is expected to grow rapidly, it may be more advantageous for the employee to pay taxes at the grant date fair market value as this amount may be significantly less than the fair market value at the later vesting date(s).

After the Section 83(B) election is made, the employee will not pay taxes until the stock is sold, at which point either a capital gain or loss tax will be applicable. The downside to making a Section 83(B) election is the potential to pay tax on what could later become worthless stock. Although, often, the stock has little to no value at the date of grant, and therefore the tax consequences are minimal.

 

Typical Valuation Procedures

To comply with IRC Sections 409(A) and 83(B), a fair market value indication is usually required for the securities in question. The IRS defines fair market value as “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” Normally a fair market value indication is only needed at the time of grant for an RSA to comply with Section 83(B). As it relates to granting stock options or SARs, the IRS has indicated a 409(A) valuation is valid for up to 12 months after the effective date or until a material event occurs (i.e., round of financing or other noteworthy event).

Depending on the stage and financial profile of the start-up company, the three core valuation approaches still apply. If the company is at a very early stage, prior to any revenues or thirdparty financing, the asset approach may be most appropriate. This is usually the case when there is limited or no data relevant to the market or income approaches.

The income approach, whereby a projected future cash flow stream is discounted back to a present value as of today, is generally the preferred approach to use. However, oftentimes reliable prospective financial information is not available, precluding the use of the income approach. As a company gets closer to profitability or once the projections become more reliable, the income approach can be the most appropriate approach.

Once the company has started to gain traction operationally, or third-party financing has been secured, the market approach is a common approach to use. Early-stage businesses are usually valued based on a multiple of revenue. In contrast, the valuation of later-stage start-ups tends to be based upon cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA), although a multitude of metrics can be used.

The guidance of a professional valuation advisor becomes especially important when considering the various types of equity that can be issued by start-ups. In a typical valuation with a simple capital structure, once a value indication of the overall company equity is derived, a pershare value can easily be calculated by dividing the equity value by the total shares outstanding. For start-ups, the capital structure is seldom simple, with investors requiring special provisions including preferred stock, convertible debt, and warrants, among others. These additional intricacies require consideration of the waterfall proceeds to each class of equity holder upon a liquidation, often necessitating the use of complex option pricing models.

 

Conclusion

If your company or start-up is experiencing any growing pains similar to what is outlined above, from the question of tax implications for stock compensation plans or the valuation of securities within a complex capital structure, please do not hesitate to contact us. Lutz has experience in these matters and is available to help.

ABOUT THE AUTHOR

402.514.0015

mgreteman@lutz.us

LINKEDIN

MICHAEL GRETEMAN + M&A MANAGER

Michael Greteman is an M&A Manager at Lutz with over six years of relevant experience. His primary responsibilities include assisting with merger and acquisition projects and providing valuation services for estate and gift taxes, litigation support, marital dissolution matters, complex equity structures, and financial/tax reporting. He focuses on analyzing and interpreting company historical and projected financial data and financial modeling.

AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
  • Accredited in Business Valuation
  • American Institute of Certified Public Accountants, Member
  • Certified Public Accountant
EDUCATIONAL BACKGROUND
  • MAC, Creighton University, Omaha, NE
  • BSBA, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • St. Margaret Mary Catholic Church, Volunteer
  • Big Brothers Big Sisters of the Midlands, Past Volunteer
  • Siena Francis Homeless Shelter, Past Volunteer

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Factors Driving Elevated Deal Valuation Environment in the Private Equity World

Factors Driving Elevated Deal Valuation Environment in the Private Equity World

 

LUTZ BUSINESS INSIGHTS

 

Factors driving deal valuation

factors driving elevated deal valuation environment in the private equity world

mark otte, m&a manager

 

As we begin 2022 with expectations of strong continued M&A activity, we wanted to recap the main 2021 deal valuation drivers. The historic economic recovery was a key theme in 2021, along with high deal volume, leading to robust valuation multiples in the low-to-middle market.

According to GF Data, the average valuations in the third quarter of 2021 was 7.6x (Total Enterprise Value/EBITDA). This is the highest quarterly mark in the last decade. During the first and second quarters of 2021, valuation multiples averaged 7.1x. GF Data provides data on private equity-sponsored M&A transactions with enterprise values of $10 to $250 million.

Below we highlight the main factors that helped drive record-high valuations in 2021.

1. Record private equity dry powder

The amount of capital chasing deals has caused valuations to spike. Private equity dry powder was at a record level of nearly $920 billion as of fall 2021. This increase in dry powder is partially generated by the growing number of institutional investors turning towards private equity investments.

2. Solid demand for quality assets/businesses

Deal volume in the lower middle market continued its rebound in 2021, with deal count for the second half of the year higher by 48% from the same period in 2020.1 In just one year since COVID began, US deal volume reached its pre-COVID peak levels. Private equity buyers have continued to show strong interest in quality investment opportunities, particularly for platform acquisitions, which have tended to be valued slightly higher than add-ons.2

3. Economic stimulus has led to favorable conditions

Increases in the money supply and boosts from fiscal stimulus programs have improved the overall economic stability. Legislative relief packages such as the CARES Act and Consolidated Appropriations Act have supported the overall economic recovery. This, in part, has led to high expectations from investors for future business growth and their willingness to acquire high-performing businesses at a premium.

4. “Value bridge” concept is at the deal forefront

Acquisitions vetted through this concept include numerous value levers/dynamics. Through detailed due diligence and data analytics, buyers uncover value creation opportunities which allow higher buy-out multiples. There are three main areas where experienced buyers can create value post-acquisition:

  • Strategic positioning – (i.e., business model and market focus)
  • Performance improvement – (i.e., growth opportunities, profit margins, risks and headwinds)
  • Asset optimization – (i.e., tax efficiency, net working capital and capital expenditure requirements, etc.)

If a buyer can get comfortable with the seller’s baseline enterprise value and understand the value creation opportunities of the target, the buyer may be more inclined to offer a strong bid price to remain competitive with other potential acquirers.

5. Ongoing digital revolution

Companies adopting digital technologies will continue to be in high demand. As the digital revolution was magnified by COVID-19, it became clear that technology fundamentally changed many business models. Buy-out targets who have created competitive advantages through technology improvements have been rewarded with high valuations.

6. Increase in the amount of debt financing

As more and cheaper debt is available to fund acquisitions, a company’s return on equity increases (although so does the risk). According to GF Data, the 2021 third quarter transactional total debt/EBITDA multiple reached 4.1x. In 2020, a typical debt/EBITDA multiple ranged from 3.3x – 3.8x. The current low interest rate environment has led to a greater ability to leverage financially sound businesses, leading to higher valuation multiples.

7. Deal price structure includes an earnout

An earnout is an agreement between the buyer and seller in which a portion of the purchase price is paid contingent on the business achieving certain defined financial metrics – such as revenue growth or EBITDA targets. The benefit of an earnout is to help bridge valuation gaps seen between the buyer and seller. A target’s enterprise value may include a lofty earnout, leading to a perceived higher valuation multiple, although there is no guarantee of the earnout being achieved.

For businesses that have performed better than most in their industry, the extraordinary valuation gap has been shown in the successful deals completed in 2021. GF Data reported the “quality premium” – the reward in valuation for above-average financial performance, led to a 28% increase of the seller’s EBITDA multiple. GF Data defines above-average performers as businesses with trailing 12-month EBITDA margins and revenue growth rates both above 10%, or one above 12%, and the other metric at least 8%.

It is important to keep in mind that not all businesses are generating higher than average valuation multiples when selling. During periods of economic and financial uncertainty, it is typical to see a “flight to quality” by investors. This has been a common theme among private equity managers who have chosen to invest in higher-quality, resilient businesses that have been able to withstand COVID-19 disruptions.

Are you considering M&A options for your business? Lutz M&A can help! Our team has the expertise to assist both sellers and buyers in navigating the deal market. Please contact us if you are interested in learning more.

 

1. PwC Deals 2022 Outlook

2. GF Data®

ABOUT THE AUTHOR

402.827.2032

motte@lutz.us

LINKEDIN

MARK OTTE + M&A MANAGER

Mark Otte is an M&A Manager at Lutz with over five years of consulting and valuation experience. His primary responsibilities include assisting with merger and acquisition projects and providing valuation services for estate and gift taxes, litigation support, marital dissolution matters, purchase price allocations and financial/tax reporting. He focuses on analyzing and interpreting company historical and projected financial data and financial modeling.

AFFILIATIONS AND CREDENTIALS
  • Iowa Society of Certified Public Accountants, Member
  • Nebraska Society of Certified Public Accountants, Member
  • American Institute of Certified Public Accountants, Member
  • Certified Public Accountant
  • Accredited in Business Valuation
EDUCATIONAL BACKGROUND
  • Bachelor's of Accounting, University of Northern Iowa, Cedar Falls, IA

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Quater Four Middle Market M&A Report 2021

Quater Four Middle Market M&A Report 2021

 

LUTZ BUSINESS INSIGHTS

 

Q4-21 M&A Report

Quarter four middle market M&A report 2021

In 2021, we observed an unprecedented increase in transaction volume across all industries. With easy access to capital, low interest rates, and a recovering global economy, deal making volume in Q4-21 continued to soar, growing by nearly 10% from the prior quarter and 23.7% from same period in 2020. The total value of lower middle market deals announced in Q4-21 amounted to $182.7 billion.

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Lutz M&A Advises Brokers Clearing House on its Acquisition by Integrity Marketing Group

Lutz M&A Advises Brokers Clearing House on its Acquisition by Integrity Marketing Group

 

LUTZ BUSINESS INSIGHTS

 

Lutz M&A

Lutz M&A advises brokers clearing house on its acquisition by integrity marketing group

Lutz M&A recently announced that it served as the exclusive financial advisor to Brokers Clearing House Ltd. (“BHC”) in connection with its recent acquisition by Integrity Marketing Group (“Integrity”). Integrity is an Insurtech company innovating insurance with a singular purpose in mind: to help people protect their life, health and wealth. They strive to make the process of securing health and financial wellbeing more simple, beneficial and human. Since their founding in 2006, they have grown to be the nation’s leading independent distributor of life and health insurance products. Integrity operates out of Dallas, Texas.

BHC helps match clients with the best underwriters, accountants, sales experts and legal professionals specific to their needs. In 1955, BHC became a founding member of LifeMark Partners, a national insurance marketing organization, allowing them to combine the talents and resources of more than 50 of the best brokerage firms in the United States. BHC operates out of West Des Moines, Iowa.

“We really enjoyed working with Bill Kenedy and the Lutz M&A team,” said Dan Allison, Managing Partner at Brokers Clearing House. “They were able to help us navigate the deal from due diligence to final closing. We are very happy with the results of the transaction. M&A can be a long and confusing process and we are grateful to have a partner like Lutz on our side.”

Commenting on the transaction for Lutz M&A, Bill Kenedy said, “We appreciated the opportunity to work with Dan Allison and the BCH team on this transaction. Integrity made perfect sense as a buyer as they shared the same goal of connecting clients with the best opportunities for securing their financial wellbeing. We believe the combination of BCH and Integrity will produce great solutions for their customers nation-wide.”

About Lutz M&A, LLC: Lutz M&A is a Nebraska-based mergers and acquisitions advisory firm, serving lower middle-market businesses in the Midwest across a range of industries. Lutz M&A is committed to providing its clients with a comprehensive, skilled and professional marketing process not typically available to smaller market companies. For more information, visit www.lutz.us.

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Quarter Three Middle Market M&A Report 2021

Quarter Three Middle Market M&A Report 2021

 

LUTZ BUSINESS INSIGHTS

 

Quarter three middle market M&A report 2021

The global mergers and acquisitions market reached new record highs in Q3-21 as companies who are flush with cash look to take advantage of current macroeconomic trends and emerge from the pandemic with new capabilities and growth opportunities. The total deal value in the lower middle market increased by a staggering 109.6% from Q2-21 and 202.2% from the same quarter in 2020. Deal count also increased 4.9% q/q to 3,910. Total M&A activity is expected to remain strong through the end of 2021, resulting in total expected deal values in 2021 that surpass those recorded in each of the previous three years.

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Succession Plans for Family-Owned Businesses: Why You Should Start Now

Succession Plans for Family-Owned Businesses: Why You Should Start Now

 

LUTZ BUSINESS INSIGHTS

 

Succession plans for family-owned businesses: why you should start now

RYAN MCGREGOR, consulting DIRECTOR

 

Running a business is a challenging but rewarding endeavor. For many business owners, one of the most meaningful facets of the experience includes making the business a family affair, usually by handing the reins of the business to a family member at some point in their life. While it tends to be an afterthought for many owners, succession planning for a family-owned business is key to leaving behind a strong and impactful legacy. Today, I will discuss the premise of succession planning, common mistakes, and tactics to build a strong succession plan for your family-owned business.

 

Succession Plans in Family-Owned Businesses 

Succession planning for family-owned businesses involves creating a plan for when a company’s leadership has to step down, whether for retirement, health reasons, or other life events. While many family-owned businesses hope to pass their company on to the next generation, there is often no plan in place to do this effectively. It is estimated that 70% of family-owned businesses will not make it to the second generation and 90% won’t make it to the third generation.

Thus, the first step to ensuring a successful transfer is deciding to partake in succession planning. This can be a lengthy process, but with good reason. There are a lot of decisions to be made, including what’s pertinent for the business and the family. Generally, it is estimated that good succession planning takes several years. Getting ahead of this helps ensure that your business and legacy survive a generational transfer.

 

Common Mistakes in Succession Planning

It shouldn’t be surprising that there are often many mistakes made during the succession planning process. Here are some of the major issues to avoid when navigating a plan for your business.

1. Setting and maintaining personal and professional boundaries

When it comes to family businesses, there are a lot of emotions and expectations attached to succession. This can result in unintended conflict, ruptured relationships, and negative impacts on the business. It is important to set personal and professional boundaries early on to help manage everyone’s expectations throughout the process.

2. Procrastination

Most business owners know they need a plan. However, taking the time to put a plan in place could require significant time and resources so they put it off with the thought they have plenty of time. The problem with that is many exits are involuntary. As a business owner you do not want your family to deal with the emotions of a loss and on top of that figure out how to protect their financial safety net as well. Therefore, families should do their best to start the process early, giving them plenty of time for contingencies or bumps along the road.

3. Insufficient research

Often, business owners don’t consider all their options. This may include choosing someone unexpected to be the successor, such as a different family member, non-family member, or even a competitor. In parallel to the time consideration, businesses should have the time and space to do proper research, understand succession needs, and employ a plan that will best fit the business.

 

Tactics to Building a Strong Succession Plan

Understanding the common mistakes that can occur with succession planning is a great start. The next step is learning what tactics can help mitigate these mistakes and smooth the entire succession process.

1. Maintain transparency with key stakeholders

While some decisions and discussions may need to be kept quiet, general transparency to family members and employees is key. This includes letting everyone know that succession planning is occurring, offering an overview of potential options, and reminding everyone of its intent. Communication is a key to avoiding family rifts, surprising employees, or taking the business in an unintended direction.

2. Stay aligned with the organization’s personality

While family feedback is important, so is employee feedback! You don’t want to kill your organization’s culture or sense of trust through poor planning. Everyone needs to cooperate and support the organization through transition, so aligning yourself with your entire organization’s needs is key.

3. Seek professional assistance

When in doubt, consult the professionals. It cannot be stressed enough how important professional advice is to succession planning for a family business. Not only do professionals have a more objective view of the business and can advise independently in this manner, but they also are aware of considerations that a business owner may not know about or have time to manage. They will be a critical resource through succession planning.

Not sure where to look for assistance? Our team at Lutz is highly skilled in business transition consulting, including having an expert team that focuses specifically on M&A services. If you have questions on how we can help your family-owned business with succession planning, contact us for additional information.

ABOUT THE AUTHOR

Ryan McGregor

402.778.7946

rmcgregor@lutz.us

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RYAN MCGREGOR + CONSULTING DIRECTOR

Ryan McGregor is a Consulting Director at Lutz M&A with a combined 14 years of related experience. He specializes in business consulting, valuation, and sell-side advisory services.

AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
  • Alliance of Merger & Acquisition Advisors, Member
  • National Association of Certified Valuators and Analysts, Member
  • Certified Merger & Acquisition Advisor
  • Certified Valuation Analyst
EDUCATIONAL BACKGROUND
  • BSBA in Management, University of Nebraska, Kearney, NE
  • Master of Investment Management and Financial Analysis, Creighton University, Omaha, NE
  • Master’s in Business Administration, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • Past volunteer for various local nonprofit organizations including: Juvenile Diabetes Research Foundation (JDRF), Habitat for Humanity, Red Cross and Open Door Mission

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