History of 409A Valuation

Ever wondered what led to the foundation of 409A valuations, and what were the catalysts that shaped its development? The 409A valuations, like many financial frameworks, evolved over time in response to growing needs for regulation and transparency in executive compensation. This blog outlines the key historical events that led to the development of the 409A valuations system.

Before the 1970s

Stock options were reactively business applicable before the 1970s. Their limited applications were bound to employee compensation. While their existence was acknowledged, their handling was not regulated by defined guidelines. Additionally, heuristics were the primary source that determined the company’s corporate expenses.

Companies tried to orchestrate the stock options account, but the lack of a clear framework caused discrepancies. However, the late 1960s were the time when stock options gained prominence as a method for motivating employees. Regulatory bodies paid little attention to stock options during this period due to their limited applicability and relevance.

The 1970s Era

The Accounting Principles Board (APB), which later became the Financial Accounting Standards Board (FASB), directed the regulations in the early 1970s. It was tasked to determine an appropriate accounting treatment for the issuance stock options. APB issued APB 25 in 1972, stipulating the cost of stock options should be measured at their intrinsic value, which is the difference between current market value and exercise price. However, a key aspect of APB 25 was that no cost was required to be recorded in financial statements if the options were issued at the current fair market value of the stock.

APB 25’s provision, though inventive in the era, eventually became obsolete.

The Black-Scholes formula for pricing options, published in 1973, revolutionized the market for publicly traded options, triggering reliance on stock options for employee compensation. Simultaneously, the opening of the Chicago Board Options Exchange in 1973 facilitated the growth of the traded options market, further boosting the use of stock options within businesses.

Observation & Amendments

In 1984, the Financial Accounting Standards Board (FASB) initiated a review of stock options accounting. During the period between 1973 and 1984, there were many technical developments that changed the way options were valued and perceived, such as the Black-Scholes formula. Another reason for the review was that APB 25 was like an old-school solution to a Gen Z problem, and it’s only natural because a decade is long enough for any standard to become obsolete.

The 1990s was the time of the CEOs. They were receiving hefty paychecks, which were far above what would be categorized as normal. These salaries were tax-deductible, making it extensively lucrative for executives and their employers. However, the IRS took notice of these issues and introduced an act in 1993, Section 162(m), which stated that salaries above $1 million were excessive and that anything in excess of $1 million would no longer be tax-deductible.

Although the purpose of the amendment was to deter senior executives from taking extraordinary salaries, it utterly failed to fulfill this goal. It did not take long for executives to find a way to circumvent the law. This amendment led to a collaboration between executives and their employers to pay executives with stock options rather than large salaries. This was a mutually symbiotic system for both: executives would pay fewer taxes, as they would now pay capital gains taxes (which are lower than income tax) on their stock-based compensation, and companies would pay less in taxes. Since at-the-money options are performance-based compensation, are tax-deductible when exercised. This allowed them to cheat the IRS not once, but twice.

This trend led to the issuance of stock options not just for executives but also for lower-level employees. These employees, especially younger talent, didn’t mind the chance to make money through stock options (more like a lottery) instead of receiving a higher cash payout on payday. This motivated employers to issue more and more stock options, as they did not have to record any expenses for them. Additionally, due to the booming stock market, these options, instead of being lottery tickets, were as valuable as gold. This provided a key strategic advantage to smaller companies with limited cash, as they could save their cash and simply issue more options, all while not recording any expense for the transaction.

In 1995, FASB issued SFAS 123. It recommended but did not require companies to report the cost of options granted and to determine their fair market value using option-pricing models. Inevitably, most companies chose to ignore the recommendation they had opposed so vehemently and continued to record only the “intrinsic value” at the grant date, typically zero, of their stock option grants.

Option Backdating Scandal

The option backdating scandal emerged as companies began to retroactively issue stock options on dates when the company’s stock price was at its lowest. By doing so, executives could guarantee that the options were issued at the money, thereby creating an immediate financial gain once the stock price rose.

There were several factors that facilitated option backdating. For one, APB 25 did not require the recording of expenses related to stock options, so companies had little incentive to disclose the exact dates on which stock options were granted. Additionally, SFAS 123, while recommending the use of option pricing models, did not mandate compliance, leaving companies free to ignore its provisions. This lack of transparency allowed companies to backdate options, creating windfall profits for executives at the expense of shareholders.

Notably, companies like Enron were embroiled in this scandal, taking advantage of the regulatory gaps and issuing stock options with a retroactive grant date. This situation raised serious concerns about corporate governance and the alignment of executive compensation with shareholder interests.

The Final Push

The Enron scandal, which unfolded in 2001, was the catalyst that led to significant reforms in executive compensation regulations. As the company spiraled into bankruptcy, Enron’s executives, in a final attempt to preserve their wealth, used deferred compensation plans to shelter their income. This move revealed the loopholes in the system, including the so-called “haircut provision,” which allowed executives to withdraw their deferred income at a 10% penalty but without much restriction.

In 2001, the company filed for bankruptcy, and the absence of regulations restricted the IRS. The public backlash against Enron’s practices prompted political involvement.

Evolution of the System (2002 and Beyond)

In 2002, to fight the option backdating problem, the Sarbanes-Oxley Act (SOX) was put in place. Before Sarbanes-Oxley, officers and directors did not have to disclose their receipt of stock option grants until the end of the fiscal year in which the transaction took place. So, a grant in January might not have to be disclosed until more than a year later. SOX changed that by requiring real-time disclosure of option grants. In August 2002, shortly after the law was signed, the SEC issued rules requiring that officers and directors disclose any option grants within two business days.

2003: The SEC approved changes to the listing standards of the New York Stock Exchange and the Nasdaq Stock Market that for the first time required shareholder approval of almost all equity compensation plans. Companies have to publicly disclose the material terms of their stock option plans in order to obtain shareholder approval.

2004: The FASB issued Statement of Financial Accounting Standard 123(R) (now called ASC Topic 718), which effectively eliminated the accounting advantage that had previously been given to stock options issued at-the-money. Since this new accounting rule took effect, all stock options granted to employees have to be recorded as an expense in the financial statements, whether or not the exercise price is at fair market value.

2005: Section 409A valuation was added to the Internal Revenue Code, effective January 1, 2005. Not only did 409A take away the ability to secure non-qualified benefits with concepts like the haircut provision, but it also put many restrictions on how you defer and take out money.                                      

2006: SEC proposed that public companies be required to more thoroughly disclose their awards of in-the-money options to certain executives. The Commission also proposed that companies be required to disclose the fair value of the option on the grant date, as determined under the new accounting rules.

These consecutive developments in regulations led to trend reversal, causing S&P and 500 firms to fall from 7.1 billion in 2001 to only 4 billion in 2004.

Concluding Remarks

The evolution of stock options accounting, culminating in the 409A valuations, reflects the broader push for greater transparency, fairness, and corporate accountability in executive compensation. The introduction of 409A valuations ensures that businesses correctly assess the fair market value of their stock options, eliminating the loopholes that led to abuse in the past. In today’s regulatory environment, it is essential for companies to rely on accurate and unbiased 409A valuations to maintain trust with shareholders and ensure compliance with tax laws. A proper valuation helps safeguard both the business and its stakeholders. This long journey from the informal use of stock options to the sophisticated 409A analysis mechanisms we have today underscores the importance of maintaining strong ethical standards in corporate governance.