1010-00004 · Arbor Health Technologies Inc · Analysis & Memos/Tax

memo-409a-compliance.docx DOCUMENT Funds

8 / 35 ← → ✕

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT

MEMORANDUM

From: Gregory Tan, Partner, Tax — Calderwood & Harkness LLP

To: Bernard Crawford, Responsible Partner, Labor & Employment — Calderwood & Harkness LLP Devon Archer, Lead Associate, Labor & Employment — Calderwood & Harkness LLP Aaron Whitfield, General Counsel — Arbor Health Technologies Inc.

Date: August 22, 2022

Re: Section 409A Compliance Analysis — Proposed Compensation Package for Dr. Marcus J. Elliston, Prospective Chief Operating Officer, Arbor Health Technologies Inc.

Matter No.: 1010-00004

Client No.: 81-30294

I. Executive Summary and Purpose

This memorandum analyzes the application of Internal Revenue Code ("Code") Section 409A to the proposed compensation package for Dr. Marcus J. Elliston ("Dr. Elliston") in connection with his prospective appointment as Chief Operating Officer ("COO") of Arbor Health Technologies Inc. ("AHT" or the "Company"), a Delaware corporation headquartered at 400 Brattle Commerce Park, Suite 1200, Cambridge, Massachusetts 02138. The purpose of this memorandum is to identify each element of the proposed compensation package that is potentially subject to Section 409A, to evaluate whether each element can be structured to be exempt from or in compliance with Section 409A, and to provide specific drafting recommendations for incorporation into the definitive Employment Agreement, Stock Option Award Agreement, and Restricted Stock Unit Award Agreement currently under preparation by this firm.

AHT is a privately held healthcare services and software-as-a-service ("SaaS") company that operates a cloud-based clinical workflow and revenue cycle management platform serving mid-market and large hospital systems, ambulatory surgical centers, and multispecialty physician groups across 32 states. The Company's equity ownership is distributed as follows: approximately 68% of outstanding equity is held by Ridgeline Capital Partners, LP ("Ridgeline"), a Boston-based private equity firm that acquired AHT in a take-private transaction in December 2019; approximately 14% is held by Helix Ventures Fund III, LP ("Helix Ventures"), an early-stage venture investor that retained its position through the take-private; and approximately 18% is held by management and other holders, including founders, employees, and certain former equity holders who rolled over their interests. AHT reported approximately $127.4 million in revenue for fiscal year 2021 and currently employs approximately 620 individuals across its Cambridge headquarters, its development center in Austin, Texas, and regional offices in Nashville, Tennessee and Denver, Colorado.

The specific compensation elements analyzed in this memorandum include the following:

(a) A stock option grant covering shares representing 1.25% of AHT's fully diluted equity, to be granted under the AHT 2020 Equity Incentive Plan (as amended May 2021);

(b) A restricted stock unit ("RSU") grant covering shares representing 0.50% of AHT's fully diluted equity, to be granted under the same equity plan;

(c) A one-time signing bonus of $250,000, payable within 30 days of Dr. Elliston's anticipated November 1, 2022 start date, subject to a 24-month clawback provision;

(d) An annual performance bonus with a target of 75% of Dr. Elliston's $575,000 annual base salary (i.e., a target annual bonus of $431,250), with a maximum payout of 150% of target (i.e., a maximum annual bonus of $646,875), based on the achievement of performance metrics to be established by the Company's Board of Directors (or a committee thereof); and

(e) Severance and change in control ("CIC") payments, including cash severance, accelerated equity vesting, continued health insurance coverage, and related benefits, payable upon termination without Cause or resignation for Good Reason, both outside and within the context of a change in control.

Summary Conclusion. Based on our analysis, and subject to the structuring recommendations set forth in this memorandum, each element of the proposed compensation package can be designed to either be exempt from Section 409A or comply with its requirements. Specifically, the stock option grant can be structured to fall within the stock rights exclusion of Treasury Regulation § 1.409A-1(b)(5); the RSU grant, signing bonus, and annual bonus can each be structured to qualify for the short-term deferral exemption of Treasury Regulation § 1.409A-1(b)(4); and the severance and change in control payments can be structured through a combination of the separation pay plan exemption of Treasury Regulation § 1.409A-1(b)(9), the short-term deferral exemption, and full compliance with Section 409A's permissible payment event, timing, and anti-acceleration rules. With these structuring modifications in place, the compensation package should avoid the adverse tax consequences imposed by Section 409A(a)(1), which include a 20% additional income tax on amounts includible in income, a premium interest penalty on the tax underpayment calculated from the date of the deferral, and accelerated inclusion in gross income of all deferred amounts to the extent not subject to a substantial risk of forfeiture.

Coordination with Outside Advisors. In preparing this memorandum, we have coordinated with Hargrove & Sinclair CPAs (Malcolm R. Sinclair, CPA, Lead Partner, 75 Ashbury Asset Advisors, Suite 1400, Boston, Massachusetts 02109) on valuation and computational matters relevant to the fair market value determination for the stock option exercise price and the RSU grant valuation, as well as on the Section 280G analysis being prepared separately. We have also coordinated with Sandra Okafor, Counsel in this firm's Corporate/M&A practice, who has reviewed the structural and governance provisions of the AHT 2020 Equity Incentive Plan (as amended May 2021) for compatibility with the proposed equity awards. The Section 280G/4999 excise tax analysis is the subject of a separate memorandum being prepared by the undersigned and Nadia Petrov, Senior Associate in our Tax practice, with an anticipated finalization date of September 2, 2022.

II. Background on Section 409A

A. Statutory Overview

Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 (Pub. L. 108-357, § 885) in response to perceived abuses in nonqualified deferred compensation arrangements, particularly those highlighted in connection with the Enron Corporation bankruptcy and related corporate scandals. Section 409A imposes comprehensive requirements on the design and administration of arrangements that provide for the deferral of compensation. The statute is broadly drafted and applies to virtually all forms of nonqualified deferred compensation, including supplemental executive retirement plans, nonqualified stock options (if improperly structured), phantom equity arrangements, bonus deferral programs, and severance agreements, among others.

The final Treasury regulations under Section 409A were published on April 17, 2007 (T.D. 9321, 72 Fed. Reg. 19,234), and became generally effective on January 1, 2009. Since that time, the Internal Revenue Service ("IRS") has issued additional guidance through notices, revenue rulings, and informal guidance, including Notice 2010-6 (providing limited correction procedures for certain 409A failures), Notice 2010-80 (addressing in-kind benefits and reimbursements), and proposed regulations on the definition of "service recipient stock" (REG-148326-05). The regulations are extensive and highly technical, and compliance requires careful attention to drafting, administration, and documentation.

B. Key Substantive Requirements

Section 409A imposes three principal sets of requirements on nonqualified deferred compensation arrangements:

Permissible Payment Events. Amounts of deferred compensation may be paid only upon the occurrence of one or more of the following six permissible payment events specified in Section 409A(a)(2)(A): (i) separation from service (as defined in Treasury Regulation § 1.409A-1(h)); (ii) the date the participant becomes disabled (as defined in Treasury Regulation § 1.409A-3(i)(4)); (iii) death; (iv) a specified time or pursuant to a fixed schedule; (v) a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation (each, a "change in control event" as defined in Treasury Regulation § 1.409A-3(i)(5)); or (vi) the occurrence of an unforeseeable emergency (as defined in Treasury Regulation § 1.409A-3(i)(3)). Payments made at any other time or for any other reason constitute impermissible early payments that violate Section 409A.

Initial Deferral Election Rules. Elections to defer compensation must generally be made no later than the close of the taxable year preceding the year in which the services giving rise to the compensation are performed. Section 409A(a)(4)(B). An exception applies for the first year of eligibility under a new plan or arrangement, in which case the election may be made within 30 days of the date the participant first becomes eligible, but only with respect to compensation attributable to services performed after the date of the election. Treasury Regulation § 1.409A-2(a)(7). Additional rules apply to performance-based compensation, fiscal year compensation, and certain other specific arrangements.

Subsequent Deferral Election and Anti-Acceleration Rules. Once a deferral election has been made (or, in the case of an employer-established payment schedule, once the payment schedule has been set), changes to the time and form of payment are strictly limited. A subsequent deferral election is permitted only if: (i) the new election is made at least 12 months before the date the payment was originally scheduled; (ii) the new election delays the payment by at least five years from the originally scheduled payment date; and (iii) if the payment event is a specified time or fixed schedule, the new election is not effective for 12 months. Section 409A(a)(4)(C). Separately, Section 409A(a)(3) and Treasury Regulation § 1.409A-3(j) prohibit the acceleration of any payment of deferred compensation, subject to limited exceptions (e.g., payment of employment taxes, domestic relations orders, conflicts of interest, de minimis cashouts).

C. Consequences of Noncompliance

The consequences of failing to comply with Section 409A are severe and are imposed on the service provider (i.e., Dr. Elliston), not on the service recipient (i.e., AHT). Specifically, Section 409A(a)(1) provides that if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of Section 409A(a), or is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. In addition to this accelerated income inclusion, the service provider is subject to: (i) an additional tax equal to 20% of the compensation required to be included in income; and (ii) a premium interest penalty calculated at the underpayment rate plus one percentage point, applied from the date the compensation was first deferred (or, if later, the date it was no longer subject to a substantial risk of forfeiture). These penalties can be financially devastating for senior executives with significant deferred compensation balances, and they cannot be grossed up or indemnified by the employer without creating additional 409A complications.

D. Exemptions from Section 409A

Critically, not all forms of compensation constitute "deferred compensation" for purposes of Section 409A. The Treasury regulations provide several important exemptions, and arrangements should be structured to fall within these exemptions wherever possible. The most commonly applicable exemptions include the following:

Short-Term Deferral Rule. Treasury Regulation § 1.409A-1(b)(4) provides that a payment is not treated as deferred compensation if it is paid by the 15th day of the third month following the later of (i) the end of the service provider's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture, or (ii) the end of the service recipient's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture (the "short-term deferral period"). This is the most commonly used exemption and is available for bonuses, equity awards settled promptly upon vesting, signing bonuses, and similar arrangements.

Stock Rights Exclusion. Treasury Regulation § 1.409A-1(b)(5) provides that certain stock options and stock appreciation rights ("SARs") are not treated as deferred compensation, provided they meet specific conditions relating to exercise price, the nature of the underlying stock, and the absence of deferral features. This exclusion is analyzed in detail in Section III below.

Separation Pay Exemptions. Treasury Regulation § 1.409A-1(b)(9) provides several exemptions for separation pay arrangements, including the "two-times pay" exemption (§ 1.409A-1(b)(9)(iii)) and the involuntary separation pay exemption (§ 1.409A-1(b)(9)(iii)), which are analyzed in Sections VII and VIII below.

E. Relevance of AHT's Private Company Status

AHT's current status as a privately held corporation (not publicly traded on an established securities market or otherwise) is relevant to several provisions of Section 409A and the Treasury regulations. Most notably, the "specified employee" rule of Section 409A(a)(2)(B)(i), which requires a six-month delay in separation-from-service payments to certain key employees, applies only to service recipients any stock of which is publicly traded on an established securities market or otherwise. Because AHT is currently privately held, the specified employee delay rule does not presently apply to payments under Dr. Elliston's compensation package. However, as discussed in Section IV.E below, if AHT were to undertake an initial public offering ("IPO") or become publicly traded through any other means during the term of Dr. Elliston's employment, the specified employee rule would become operative, and protective provisions should be included in the governing agreements to address this contingency. Additionally, the fair market value determination for stock option exercise prices is subject to specific rules for privately held companies, as discussed in Section III.C below.

III. Analysis of Stock Option Grant

A. Description of Proposed Grant

The proposed compensation package includes a grant of nonqualified stock options ("NQSOs") to Dr. Elliston to purchase shares of AHT common stock representing 1.25% of the Company's fully diluted equity. The options would be granted under the AHT 2020 Equity Incentive Plan, as amended in May 2021 (the "Equity Plan"), and would be governed by a Stock Option Award Agreement between AHT and Dr. Elliston. As currently proposed, the stock options would be subject to the following terms:

• Vesting Schedule: 25% cliff vesting at 12 months from the grant date, with monthly vesting of the remaining 75% over the subsequent 36 months, resulting in a four-year total vesting period;

• Exercise Price: To be set at the fair market value ("FMV") of AHT common stock as of the grant date;

• Expiration: Ten years from the grant date (subject to earlier termination upon separation from service, as specified in the Equity Plan and Stock Option Award Agreement); and

• Exercise Mechanism: The option may be exercised, in whole or in part, with respect to vested shares, by delivery of an exercise notice and payment of the aggregate exercise price and applicable tax withholding amounts.

Sandra Okafor, Counsel in the Corporate/M&A practice of this firm, has reviewed the structural and governance terms of the Equity Plan for compatibility with the proposed stock option grant and has confirmed that the plan contains sufficient share authorization and administrative provisions to support the grant. The draft Stock Option Award Agreement was prepared on August 12, 2022, and is currently under review by both Sandra Okafor and the undersigned for Section 409A compliance purposes.

B. Stock Rights Exclusion Under Treasury Regulation § 1.409A-1(b)(5)

Nonqualified stock options are generally exempt from Section 409A under the "stock rights" exclusion set forth in Treasury Regulation § 1.409A-1(b)(5)(i). Under this exclusion, the grant of a stock option does not constitute a deferral of compensation for purposes of Section 409A, and the option is therefore not subject to Section 409A's substantive requirements, provided that four conditions are satisfied:

(i) Exercise Price at or Above FMV. The option must be granted with an exercise price that may never be less than the fair market value of the underlying stock on the date of grant. Treasury Regulation § 1.409A-1(b)(5)(i)(A). If the exercise price is set below FMV (i.e., the option is "Discounted" or "in the money" at grant), the option constitutes deferred compensation subject to Section 409A from the date of grant. This requirement is a bright-line rule — even a minimal discount (e.g., an exercise price set at $9.95 when FMV is $10.00) will cause the option to fail the stock rights exclusion and become subject to Section 409A in its entirety. Notably, the exercise price must never be less than FMV, meaning that an exercise price set above FMV (a "premium" option) satisfies this requirement.

(ii) Service Recipient Stock. The option must cover "service recipient stock" within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii). Generally, this means common stock of the corporation for which the service provider performs services (or the direct or indirect parent corporation thereof). The service recipient stock requirement is discussed in greater detail in Section III.D below.

(iii) No Deferral Feature. The option must not include any feature for the deferral of compensation beyond the date of exercise and receipt of the underlying shares (or cash equivalent). Treasury Regulation § 1.409A-1(b)(5)(i)(C). This means that the option agreement may not permit the holder to exercise the option and elect to receive the shares at a later date, and may not provide for automatic deferral of share delivery following exercise. The prohibition on deferral features is discussed in Section III.E below.

(iv) Subject to Section 83 Taxation. The stock acquired upon exercise of the option must be subject to taxation under Section 83 of the Code. Treasury Regulation § 1.409A-1(b)(5)(i)(A). This requirement is generally satisfied for options granted to employees and is not expected to present any issue for Dr. Elliston's options.

If all four conditions are met, the stock option is fully exempt from Section 409A for the entirety of its term, from grant through exercise, and no Section 409A compliance provisions need to be incorporated into the Stock Option Award Agreement (though including a general 409A savings clause is nonetheless recommended as a matter of best practice).

C. Fair Market Value Determination — Section 409A Valuation Requirements

The most critical compliance element for the stock option grant is ensuring that the exercise price is set at or above the FMV of AHT common stock on the date of grant. Because AHT is a privately held company whose stock is not traded on an established securities market, FMV cannot be determined by reference to market trading prices. Instead, Treasury Regulation § 1.409A-1(b)(5)(iv)(B) provides that FMV must be determined by the "reasonable application of a reasonable valuation method." The regulations identify several factors that are relevant to whether a valuation method is reasonable, including the value of tangible and intangible assets, the present value of anticipated future cash flows, the market value of stock or equity interests in similar corporations engaged in similar trades or businesses, the value of recent arm's-length transactions involving the sale or transfer of the stock, control premiums or discounts for lack of marketability, and the consistency with which the valuation method is applied.

The Treasury regulations provide three safe harbor valuation methods that, if used, create a presumption that the valuation is reasonable. The burden of proof shifts to the IRS to demonstrate that the valuation is "grossly unreasonable." The three safe harbors are:

(1) Independent Appraisal Safe Harbor. A valuation performed by a qualified independent appraiser (as defined in Section 170(a)(1) and the regulations thereunder), provided the appraisal is conducted no more than 12 months before the relevant grant date. Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(i). This is the most commonly used safe harbor for established private companies and is the method we recommend for AHT.

(2) Formula-Based Valuation Safe Harbor. A valuation determined pursuant to a formula that is used consistently for all compensatory and noncompensatory purposes that require valuation of the stock (e.g., the same formula is used in buy-sell agreements, shareholder agreements, and regulatory filings). Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(ii). This safe harbor is available only if the formula is used consistently for all such purposes, which may be difficult to satisfy if AHT uses different valuation methodologies in different contexts (e.g., a different methodology for the Ridgeline Capital Partners Stockholders' Agreement repurchase provisions than for equity compensation grants).

(3) Start-Up Company Safe Harbor. A valuation performed by a person or persons with significant knowledge and experience in performing valuations of similar companies, applied to an "eligible start-up" — generally, a company that (a) has been in active trade or business for less than 10 years, (b) has no class of equity securities traded on an established securities market, and (c) does not reasonably anticipate a change in control event within 12 months or an IPO within 180 days. Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(iii). This safe harbor is likely inapplicable to AHT given the Company's $127.4 million in fiscal year 2021 revenue, approximately 620 employees, and operational maturity. AHT does not appear to qualify as an "eligible start-up" within the meaning of the regulation.

Recommendation. AHT should obtain an independent 409A valuation (commonly referred to in practice as a "409A valuation" or "fair market value appraisal") from a qualified independent appraiser prior to the date on which the stock options are granted to Dr. Elliston. The valuation should be coordinated through AHT's internal finance team, specifically Derek Solano, Chief Financial Officer, and with the assistance of Hargrove & Sinclair CPAs (Malcolm R. Sinclair, CPA, Lead Partner). The independent appraisal should employ methodologies appropriate for a private SaaS/healthcare services company of AHT's size and profile, which would typically include a combination of (a) a discounted cash flow analysis, (b) a comparable public company analysis (using publicly traded SaaS and healthcare IT companies as comparables), and (c) a comparable transaction analysis (referencing recent private market transactions in the healthcare SaaS sector).

We note that AHT's December 2019 take-private by Ridgeline Capital Partners, completed at an enterprise value of approximately $340 million, provides a useful historical reference point for understanding the Company's valuation trajectory. However, a current independent appraisal is essential given the more than two-and-a-half years that have elapsed since the take-private, during which AHT has experienced significant revenue growth, expansion of its product platform, and changes in market conditions (both favorable and unfavorable) for healthcare SaaS companies. Reliance on the 2019 take-private valuation alone would not constitute a reasonable valuation method under the Treasury regulations.

Additionally, the AHT 2020 Equity Incentive Plan (as amended May 2021) should contain — or be amended to contain — language requiring that the exercise price of any nonqualified stock option granted under the plan shall not be set below the FMV of the underlying stock on the date of grant, as determined in compliance with Section 409A and the Treasury regulations thereunder. We understand that the current version of the Equity Plan contains a general provision to this effect, but we recommend that Sandra Okafor confirm the adequacy of this language and propose any necessary amendments.

D. Service Recipient Stock Requirement

The stock underlying the option must constitute "service recipient stock" within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii). Service recipient stock is defined as common stock of the "eligible issuer of service recipient stock," which is the corporation for which the service provider performs services (or the corporation that is the direct or indirect majority owner thereof). For purposes of this rule, the determination of the direct or indirect majority owner is made by applying the rules of Section 414(b) and (c) (relating to controlled groups and affiliated service groups), substituting "at least 50 percent" for "at least 80 percent."

AHT is a Delaware corporation and Dr. Elliston would be providing services directly to AHT (and not to a subsidiary or affiliate). Accordingly, AHT common stock is the service recipient stock for purposes of this analysis. The proposed options would be granted on shares of AHT common stock, which satisfies this requirement. We note that the service recipient stock rules require that the stock be common stock — preferred stock, debt instruments, and phantom equity arrangements do not qualify. The AHT common stock that is the subject of the proposed option grant appears to satisfy this requirement, but the following additional considerations should be confirmed:

• The Ridgeline Capital Partners Stockholders' Agreement (to which AHT is a party) should be reviewed to confirm that there is no arrangement, understanding, or side agreement that would cause the options to be treated as options on stock of a subsidiary, parent, or other entity rather than on AHT common stock. In particular, if Ridgeline has established a blocker entity or other intermediate holding structure between its fund and AHT, the service recipient stock analysis should confirm that AHT (rather than the blocker entity) is the appropriate eligible issuer of service recipient stock.

• The Helix Ventures Fund III, LP stockholder provisions, including any anti-dilution protections, preemptive rights, and consent provisions applicable to the issuance of equity under the Equity Plan, should be reviewed to confirm that they do not create features or conditions that would compromise the stock rights exclusion. For example, if the Helix Ventures stockholder rights include a provision granting Helix Ventures a right to acquire shares from option holders upon exercise (a "call right" or "right of first refusal"), this provision should be evaluated to confirm that it does not constitute a deferral feature or otherwise impair the stock rights exclusion.

Preliminary Conclusion. Based on our preliminary review, and subject to confirmation of the foregoing items, the proposed options would be granted on AHT common stock that constitutes service recipient stock within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii), thereby satisfying this element of the stock rights exclusion.

E. Prohibition on Deferral Features

The stock rights exclusion requires that the option not include any "feature for the deferral of compensation" beyond the date of exercise. Treasury Regulation § 1.409A-1(b)(5)(i)(C). A deferral feature includes any provision that would permit the holder, upon exercise, to receive something other than the underlying stock (or cash equal to the fair market value of the stock at the time of exercise) within a reasonable period following exercise. Examples of deferral features that would disqualify an option from the stock rights exclusion include:

• A provision permitting the holder to elect to receive shares at a date later than the exercise date (e.g., a "deferred delivery" election);

• A "net settlement" or "net exercise" feature that is structured in a manner that provides the holder with the spread value in a form other than the immediate delivery of shares (though certain net exercise features may be permissible if properly structured to result in the delivery of shares on the exercise date);

• A provision permitting the holder to receive the spread value in installments following exercise; and

• Any "tandem" feature linking the option to a deferred compensation arrangement (e.g., an option that converts into a deferred compensation obligation upon the occurrence of a specified event).

Recommendation. The draft Stock Option Award Agreement (prepared August 12, 2022) should be carefully reviewed to confirm that it does not include any deferral feature. Specifically, the agreement should provide that, upon exercise, the Company shall deliver the shares of AHT common stock to the option holder promptly following exercise, and in all events no later than the end of the calendar year in which the exercise occurs or, if later, within two and one-half months following the date of exercise. This latter timing provision is consistent with the short-term deferral rule under Treasury Regulation § 1.409A-1(b)(4) and provides a backup exemption from Section 409A in the event that the stock rights exclusion is determined not to apply for any reason. The agreement should also include an express representation that the option does not include any feature for the deferral of compensation beyond the date of exercise, other than the period reasonably necessary to accomplish the administrative delivery of shares.

F. Conclusion on Stock Options

If the proposed stock option grant is structured in accordance with the foregoing requirements — specifically, (i) the exercise price is set at or above the FMV of AHT common stock on the grant date, as determined by a qualified independent appraisal; (ii) the options cover AHT common stock that constitutes service recipient stock; (iii) the Stock Option Award Agreement does not include any feature for the deferral of compensation beyond exercise and payment; and (iv) the stock acquired upon exercise is subject to taxation under Section 83 — then the proposed stock option grant should be fully exempt from Section 409A under the stock rights exclusion of Treasury Regulation § 1.409A-1(b)(5). No Section 409A compliance provisions (such as permissible payment event restrictions, specified employee delays, or anti-acceleration provisions) would be required with respect to the options, though we recommend including a general Section 409A savings clause as a matter of best practice.

IV. Analysis of Restricted Stock Unit (RSU) Grant

A. Description of Proposed Grant

The proposed compensation package includes a grant of restricted stock units ("RSUs") covering shares of AHT common stock representing 0.50% of the Company's fully diluted equity. The RSUs would be granted under the AHT 2020 Equity Incentive Plan (as amended May 2021) and would be governed by a Restricted Stock Unit Award Agreement between AHT and Dr. Elliston. As currently proposed, the RSUs would be subject to the following terms:

• Vesting Schedule: 33.33% vesting annually over a three-year period from the date of grant, with each tranche vesting on the applicable anniversary of the grant date;

• Settlement: Shares of AHT common stock to be delivered upon each vesting date (i.e., mandatory settlement upon vesting, as currently drafted); and

• Change in Control Acceleration: Full acceleration of all unvested RSUs upon a qualifying termination (termination without Cause or resignation for Good Reason) occurring within 24 months following a change in control of the Company (commonly referred to as a "double-trigger" acceleration provision).

B. RSUs Are Potentially Subject to Section 409A

Unlike stock options that meet the stock rights exclusion described in Section III above, RSUs do not benefit from a specific statutory or regulatory exclusion from Section 409A. This is because RSUs represent a contractual promise by the employer to deliver shares of stock (or a cash equivalent) at a future date, contingent upon the satisfaction of vesting conditions. Unlike a stock option, which requires the service provider to pay an exercise price in order to acquire shares, an RSU entitles the holder to receive shares (or cash) without any additional payment. As a result, an RSU is functionally a promise to deliver property at a future date and is generally treated as a "deferral of compensation" within the meaning of Section 409A, unless the RSU qualifies for an available exemption.

The most commonly applicable exemption for RSUs is the short-term deferral rule under Treasury Regulation § 1.409A-1(b)(4), which is available if the shares are delivered within a specified period following the lapse of the substantial risk of forfeiture (i.e., vesting). If the RSUs do not qualify for the short-term deferral exemption — for example, because the RSU agreement provides for settlement at a date significantly later than the vesting date — then the RSUs constitute deferred compensation fully subject to Section 409A, and all of Section 409A's substantive requirements (permissible payment events, anti-acceleration, specified employee delay, etc.) must be satisfied.

C. Short-Term Deferral Exemption — Treasury Regulation § 1.409A-1(b)(4)

Under the short-term deferral rule, a payment is not treated as a deferral of compensation subject to Section 409A if the payment is made by the 15th day of the third month following the later of: (i) the end of the service provider's taxable year in which the right to the payment is no longer subject to a "substantial risk of forfeiture" (as defined in Treasury Regulation § 1.409A-1(d)), or (ii) the end of the service recipient's taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. For RSUs, the "substantial risk of forfeiture" generally lapses on the applicable vesting date, at which point the participant has an unconditional right to receive the shares.

Practical Application. AHT's taxable year is the calendar year, and Dr. Elliston's taxable year is also the calendar year (as is the case for virtually all individual taxpayers). Accordingly, for each tranche of RSUs that vests on a given anniversary of the grant date, the short-term deferral period extends through March 15 of the calendar year following the year of vesting. By way of example, if the grant date is November 15, 2022:

• Tranche 1 (33.33%): Vests on November 15, 2023. Short-term deferral period ends March 15, 2024. Shares must be delivered by March 15, 2024.

• Tranche 2 (33.33%): Vests on November 15, 2024. Short-term deferral period ends March 15, 2025. Shares must be delivered by March 15, 2025.

• Tranche 3 (33.34%): Vests on November 15, 2025. Short-term deferral period ends March 15, 2026. Shares must be delivered by March 15, 2026.

Recommendation. The RSU Award Agreement should be drafted to require mandatory settlement (i.e., delivery of shares of AHT common stock) within the short-term deferral window following each vesting date. Specifically, we recommend that the agreement provide that settlement shall occur within 60 days following each applicable vesting date, and in no event later than March 15 of the calendar year following the calendar year in which the applicable vesting date occurs. The 60-day settlement window provides AHT with administrative flexibility to process the settlement and arrange for share delivery and tax withholding, while the March 15 outside date ensures that the short-term deferral exemption is preserved even if administrative delays occur.

The draft RSU Award Agreement (prepared August 12, 2022, reviewed by Sandra Okafor and the undersigned) should be reviewed to confirm that it incorporates these settlement timing provisions. In particular, the draft should be reviewed to confirm that there is no provision permitting Dr. Elliston to elect to defer settlement beyond the short-term deferral period, and no provision permitting AHT to unilaterally defer settlement beyond the short-term deferral period. Any such provision would cause the RSUs to constitute deferred compensation fully subject to Section 409A.

D. Change in Control Acceleration — Section 409A Implications

The proposed RSU award includes a double-trigger acceleration provision: full acceleration of all unvested RSUs upon a qualifying termination (termination without Cause or resignation for Good Reason) occurring within 24 months following a change in control of the Company. This provision raises several Section 409A considerations.

Acceleration of Vesting Distinguished from Acceleration of Payment. As an initial matter, the acceleration of vesting itself is not a Section 409A issue. The anti-acceleration rule of Section 409A(a)(3) prohibits the acceleration of the time or schedule of any payment of deferred compensation, but does not prohibit the acceleration of vesting (i.e., the removal of a substantial risk of forfeiture). The distinction is critical: when RSU vesting is accelerated, the substantial risk of forfeiture is removed earlier than originally scheduled, but the payment (i.e., the delivery of shares) can still occur within the short-term deferral period following the new, earlier vesting date. Provided that settlement occurs within the short-term deferral window following the accelerated vesting date, the RSUs remain within the short-term deferral exemption and Section 409A is not implicated. Treasury Regulation § 1.409A-3(j)(1) (anti-acceleration rule does not apply to amounts that are not "deferred compensation" because they satisfy the short-term deferral exemption).

Change in Control Definition Conformity. Although the acceleration of RSU vesting upon a change in control does not itself trigger Section 409A concerns (provided settlement occurs within the short-term deferral period), the definition of "change in control" used in the Employment Agreement and RSU Award Agreement is nonetheless important and should be evaluated for conformity with Section 409A. This is because the same definition of "change in control" is used to trigger the enhanced severance payments under the Employment Agreement (discussed in Section VIII below), which do constitute deferred compensation subject to Section 409A.

The proposed Employment Agreement defines "change in control" as follows:

(i) The acquisition of more than 50% of the outstanding voting securities of AHT by any person or group of affiliated persons (other than Ridgeline Capital Partners, LP or its affiliates);

(ii) The consummation of a merger, consolidation, or sale of all or substantially all of the assets of AHT, in which the existing stockholders of AHT retain less than 50% of the voting power of the surviving or acquiring entity;

(iii) The complete liquidation or dissolution of AHT; and

(iv) A change in the majority composition of the Board of Directors of AHT (other than changes approved by a majority of the incumbent Board).

This definition must be evaluated against the three categories of Section 409A-compliant change in control events set forth in Treasury Regulation § 1.409A-3(i)(5):

(a) Change in ownership of a corporation. A change in the ownership of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, together with stock held by such person or group, constitutes more than 50% of the total fair market value or total voting power of the stock of such corporation. Treasury Regulation § 1.409A-3(i)(5)(v). The proposed definition's trigger (i) is broadly consistent with this category, subject to the Ridgeline carve-out discussed below.

(b) Change in effective control of a corporation. A change in the effective control of a corporation occurs on the date that (I) any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 30% or more of the total voting power, or (II) a majority of the members of the Board of Directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the Board of Directors prior to the date of the appointment or election. Treasury Regulation § 1.409A-3(i)(5)(vi). The proposed definition's trigger (iv) is broadly consistent with the Board replacement prong of this category.

(c) Change in ownership of a substantial portion of the assets of a corporation. A change in the ownership of a substantial portion of the assets of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation that have a total gross fair market value equal to or more than 40% of the total gross fair market value of all of the assets of the corporation immediately prior to such acquisition or acquisitions. Treasury Regulation § 1.409A-3(i)(5)(vii). The proposed definition's trigger (ii) (merger, consolidation, or sale of substantially all assets) is broadly consistent with this category, and trigger (iii) (complete liquidation or dissolution) may also fall within this category depending on the circumstances.

Ridgeline Capital Partners Carve-Out. The proposed definition excludes from the definition of "change in control" any acquisition of AHT voting securities by Ridgeline Capital Partners, LP or its affiliates. This carve-out is permissible under Section 409A, because the Treasury regulations permit the contractual definition of "change in control" to be narrower than the regulatory definition. The regulations do not require that every transaction meeting the regulatory definition of a change in control event trigger a payment; they require only that no payment be triggered by an event that does not meet the regulatory definition. Accordingly, the Ridgeline carve-out (which narrows the range of transactions that constitute a change in control under the Employment Agreement) does not create a Section 409A compliance issue, so long as the remaining triggers in the contractual definition are congruent with or narrower than the corresponding categories under Treasury Regulation § 1.409A-3(i)(5).

Recommendation. We recommend that the following steps be taken with respect to the change in control definition:

(i) Include a provision in both the Employment Agreement and the RSU Award Agreement stating that, to the extent any payment or benefit constitutes "nonqualified deferred compensation" within the meaning of Section 409A, a "change in control" shall not be deemed to have occurred unless such event also constitutes a "change in control event" within the meaning of Treasury Regulation § 1.409A-3(i)(5). This "409A overlay" provision ensures that any deferred compensation payment triggered by a change in control will satisfy Section 409A's permissible payment event requirement.

(ii) If the RSUs remain within the short-term deferral exemption (which they should, provided settlement occurs within the short-term deferral window following any accelerated vesting), the conforming change in control definition is less critical for the RSUs themselves. However, the conforming definition remains critical for the severance payments discussed in Sections VII and VIII below, and including the provision in the RSU Award Agreement as well provides an additional layer of protection and consistency across the compensation package.

E. Specified Employee Rule — Contingency Planning if AHT Goes Public

Section 409A(a)(2)(B)(i) provides that, in the case of any "specified employee" (as defined in Section 409A(a)(2)(B)(ii)), distributions of nonqualified deferred compensation that are payable on account of separation from service shall not be made before the date that is six months after the date of separation from service (or, if earlier, the date of death). This six-month delay requirement applies only to service recipients whose stock is "publicly traded on an established securities market or otherwise." Section 409A(a)(2)(B)(i)(I). A "specified employee" is generally a key employee of the service recipient, as determined under the rules of Section 416(i) — typically, an officer with annual compensation exceeding a specified threshold ($200,000 for 2022), a five-percent owner, or a one-percent owner with annual compensation exceeding $150,000.

AHT is currently a privately held corporation whose stock is not publicly traded on an established securities market or otherwise. Accordingly, the specified employee delay rule does not currently apply to payments under Dr. Elliston's compensation package. This means that, under current circumstances, any separation-from-service payments that constitute deferred compensation under Section 409A may be made to Dr. Elliston upon separation from service without a six-month delay, regardless of his status as a key employee.

However, if AHT were to undertake an IPO, a SPAC transaction, a direct listing, or any other transaction that results in AHT's stock (or the stock of a parent or successor entity) becoming publicly traded during the term of Dr. Elliston's employment, the specified employee delay rule would become operative. Given Dr. Elliston's anticipated title (Chief Operating Officer) and compensation level (annual base salary of $575,000 plus bonus), he would almost certainly qualify as a "specified employee" under Section 416(i) in the event AHT becomes publicly traded. In that scenario, if any RSU settlement were triggered by Dr. Elliston's separation from service and constituted deferred compensation under Section 409A (i.e., did not qualify for the short-term deferral exemption because of a delayed settlement provision or administrative failure), the settlement would need to be delayed for six months following separation from service.

Recommendation. As a "belt-and-suspenders" protective measure, we recommend including a provision in the RSU Award Agreement providing that, in the event AHT becomes a publicly traded company and the RSU settlement is triggered by separation from service and constitutes nonqualified deferred compensation within the meaning of Section 409A, settlement shall be delayed until the first business day following the six-month anniversary of the date of separation from service (or, if earlier, the date of Dr. Elliston's death). We recognize that if the short-term deferral exemption applies to the RSUs (as it should, given our recommended settlement timing provisions), the specified employee delay is unnecessary as a legal matter, because the short-term deferral exemption takes the RSUs entirely outside the scope of Section 409A. Nonetheless, including the protective language guards against the possibility that the short-term deferral exemption is later determined to be unavailable (e.g., due to an administrative failure to settle within the required window), and demonstrates good faith compliance with Section 409A in the event of an IRS examination.

F. Conclusion on RSUs

If the RSU settlement is structured to occur within the short-term deferral window following each vesting date — specifically, within 60 days following the applicable vesting date, and in no event later than March 15 of the calendar year following the calendar year of vesting — the RSUs should qualify for the short-term deferral exemption of Treasury Regulation § 1.409A-1(b)(4) and should be exempt from Section 409A. This analysis applies equally to the regularly scheduled vesting dates and to any accelerated vesting upon a qualifying termination within 24 months following a change in control, provided that settlement following accelerated vesting also occurs within the short-term deferral period. Protective specified employee delay language should be included in the RSU Award Agreement as a contingency for a potential future AHT public offering, as described in Section IV.E above.

V. Analysis of Signing Bonus with Clawback

A. Description. The proposed compensation package includes a one-time signing bonus of $250,000, payable to Dr. Elliston within 30 days of his anticipated start date of November 1, 2022. The signing bonus is intended to serve as an inducement for Dr. Elliston to accept the COO position and to compensate him, in part, for compensation he will forfeit from his current employer upon resignation.

The signing bonus is subject to a 24-month clawback provision: if Dr. Elliston voluntarily resigns without Good Reason or is terminated by AHT for Cause within 24 months of his start date, he is required to repay the signing bonus. The specific terms of the clawback (whether repayment is pro-rata based on the number of months of service completed, or in full regardless of the timing of departure) are to be specified in the Employment Agreement and are currently under negotiation between AHT and Dr. Elliston's counsel, Catherine A. Fielding, Partner at Fielding & Rowe LLP.

B. Section 409A Analysis — Signing Bonus Payment

The signing bonus, as proposed, is not deferred compensation within the meaning of Section 409A because it is paid within the short-term deferral period. The analysis proceeds as follows:

The right to receive the signing bonus vests upon Dr. Elliston's commencement of employment with AHT, which is anticipated to occur on November 1, 2022. At that point, Dr. Elliston has a legally binding right to receive the $250,000 payment, and the substantial risk of forfeiture with respect to that right has lapsed. The short-term deferral period extends through the 15th day of the third month following the later of (i) the end of Dr. Elliston's taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture (December 31, 2022), and (ii) the end of AHT's taxable year in which the right is no longer subject to a substantial risk of forfeiture (December 31, 2022). Accordingly, the short-term deferral period for the signing bonus extends through March 15, 2023.

Payment of the signing bonus within 30 days of the November 1, 2022 start date (i.e., by approximately December 1, 2022) is well within the short-term deferral period of March 15, 2023. The signing bonus payment is therefore exempt from Section 409A under the short-term deferral rule of Treasury Regulation § 1.409A-1(b)(4).

Conclusion. The signing bonus payment, as currently structured, is exempt from Section 409A under the short-term deferral rule. No Section 409A compliance provisions are required with respect to the signing bonus payment itself.

C. Section 409A Analysis — Clawback Obligation

The 24-month clawback provision creates a repayment obligation — that is, an obligation for Dr. Elliston to return previously received compensation to AHT upon the occurrence of specified events (voluntary resignation or termination for Cause within 24 months). This repayment obligation is analytically distinct from a deferral of compensation.

Treasury guidance and IRS informal guidance indicate that a clawback or repayment obligation does not itself create a Section 409A deferral arrangement. The clawback operates as a separate contractual obligation, and the existence of the clawback does not convert the signing bonus from a current payment into a deferred payment. The IRS has not issued formal guidance directly addressing the Section 409A treatment of clawback provisions, but the consensus position among practitioners — supported by the structure of the Treasury regulations and informal IRS commentary — is that a clawback does not create deferred compensation, because the employee receives the payment currently and has immediate use of the funds; the clawback merely creates a contingent liability to return those funds in specified circumstances.

However, care must be taken to ensure that the clawback provision does not create a "substantial risk of forfeiture" that effectively extends the vesting period beyond the payment date, which could potentially recharacterize the arrangement. If the signing bonus were structured as a conditional payment — that is, a payment that is made but does not become "final" or "fully earned" until the expiration of the 24-month clawback period — an argument could be made that the substantial risk of forfeiture does not lapse until the end of the 24-month period. In that case, the payment made on the start date would be a prepayment of an amount that does not vest until 24 months later, and the arrangement could potentially be recharacterized as deferred compensation. While we believe this argument is unlikely to prevail if properly rebutted, the risk can be eliminated through proper drafting.

Recommendation. The signing bonus provision in the Employment Agreement should be drafted in two distinct parts:

(a) Unconditional Payment. The signing bonus should be described as an unconditional payment of $250,000 to be made within 30 days of Dr. Elliston's start date. The agreement should state that the signing bonus is fully earned upon commencement of employment and is payable without condition. The language should make clear that the payment is not contingent on continued employment and is not forfeitable.

(b) Separate Repayment Obligation. The clawback should be structured as a separate, independent contractual obligation to repay the signing bonus (or a pro-rata portion thereof) upon the occurrence of specified clawback events. The repayment obligation should be set forth in a separate section or paragraph from the payment provision, and should be drafted as a covenant of Dr. Elliston running in favor of AHT, rather than as a condition to the right to receive the payment.

This two-part structure clearly distinguishes the signing bonus from deferred compensation and eliminates any argument that the payment is conditional or subject to a substantial risk of forfeiture during the 24-month clawback period.

We note that Devon Archer has prepared a separate memorandum dated August 1, 2022, analyzing the enforceability of the clawback provision under the Massachusetts Wage Act (M.G.L. c. 149, § 148 et seq.) and related Massachusetts employment law. The Section 409A analysis and the Massachusetts Wage Act analysis are independent of each other, but both should be considered in finalizing the signing bonus provision.

VI. Analysis of Annual Bonus Compensation

A. Description. The proposed compensation package includes eligibility for an annual performance bonus with the following parameters:

• Target Bonus: 75% of Dr. Elliston's $575,000 annual base salary, yielding a target annual bonus of $431,250.

• Maximum Bonus: 150% of the target bonus, yielding a maximum annual bonus of $646,875.

• Performance Metrics: The bonus will be based on the achievement of individual and company-wide performance metrics to be established by the Board of Directors of AHT (or a committee thereof) at the beginning of each performance year. The specific metrics for fiscal year 2023 (the first full performance year) are currently under negotiation between AHT and Dr. Elliston's counsel at Fielding & Rowe LLP.

• Payment Timing: To be determined and specified in the Employment Agreement. The typical practice for AHT's annual bonus program (per information provided by Aaron Whitfield) is to pay annual bonuses to senior executives in February or early March following the end of the performance year, after the Board has certified performance results.

B. Short-Term Deferral Exemption

Annual performance bonuses are one of the most common forms of compensation that can be structured to qualify for the short-term deferral exemption under Treasury Regulation § 1.409A-1(b)(4). The analysis is straightforward: the right to the annual bonus is generally subject to a "substantial risk of forfeiture" throughout the performance period, because the bonus is contingent upon the achievement of performance metrics that are not known until the end of the performance year (and, in many cases, are not certified until after the end of the performance year). The substantial risk of forfeiture lapses upon the determination that the performance conditions have been satisfied — generally, at the end of the performance year or upon the date the Board certifies performance results.

Under the short-term deferral rule, the bonus is exempt from Section 409A if it is paid by the 15th day of the third month following the later of (i) the end of Dr. Elliston's taxable year in which the bonus is earned (i.e., the performance year), and (ii) the end of AHT's taxable year in which the bonus is earned. Because both Dr. Elliston and AHT are calendar year taxpayers, and the performance period is the calendar year, the short-term deferral deadline is March 15 of the year following the performance year.

Recommendation. The Employment Agreement should specify that annual bonuses will be paid no later than March 15 of the calendar year following the performance year. This deadline should be expressed as an outside payment date that is binding on the Company, not merely a target or aspirational date. The relevant provision might read, for example: "Any annual bonus earned with respect to a performance year shall be paid no later than March 15 of the calendar year immediately following the end of such performance year." The use of a hard March 15 outside date, combined with the Company's existing practice of paying bonuses in February or early March, provides a comfortable margin within the short-term deferral window and ensures that the annual bonus is exempt from Section 409A.

C. Pro-Rata Bonus on Termination

The proposed severance provisions in the Employment Agreement include a pro-rata annual bonus for the year of termination, payable upon a qualifying termination (termination without Cause or resignation for Good Reason). The pro-rata bonus is to be calculated based on actual performance for the full performance year, pro-rated for the number of days Dr. Elliston was employed during the performance year prior to the date of termination.

This pro-rata termination bonus raises a specific Section 409A concern. If the pro-rata bonus is payable upon separation from service — that is, if separation from service is the payment trigger — rather than on the regular bonus payment schedule, the pro-rata bonus may constitute deferred compensation subject to Section 409A. This is because the right to the pro-rata bonus is conditioned on both (i) the achievement of performance metrics (which occurs at the end of the performance year) and (ii) a qualifying termination event. If the payment is triggered by the termination event and is made at a time earlier than the regular bonus payment date, the arrangement may not qualify for the short-term deferral exemption (because the vesting condition — satisfaction of performance metrics — may not have lapsed at the time of termination). Conversely, if the payment is triggered by the termination event but is made later than the short-term deferral window following the lapse of the performance condition, the arrangement is deferred compensation subject to Secti

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT
MEMORANDUM
From: Gregory Tan, Partner, Tax — Calderwood & Harkness LLP
To: Bernard Crawford, Responsible Partner, Labor & Employment — Calderwood & Harkness LLP Devon Archer, Lead Associate, Labor & Employment — Calderwood & Harkness LLP Aaron Whitfield, General Counsel — Arbor Health Technologies Inc.
Date: August 22, 2022
Re: Section 409A Compliance Analysis — Proposed Compensation Package for Dr. Marcus J. Elliston, Prospective Chief Operating Officer, Arbor Health Technologies Inc.
Matter No.: 1010-00004
Client No.: 81-30294
I. Executive Summary and Purpose
This memorandum analyzes the application of Internal Revenue Code ("Code") Section 409A to the proposed compensation package for Dr. Marcus J. Elliston ("Dr. Elliston") in connection with his prospective appointment as Chief Operating Officer ("COO") of Arbor Health Technologies Inc. ("AHT" or the "Company"), a Delaware corporation headquartered at 400 Brattle Commerce Park, Suite 1200, Cambridge, Massachusetts 02138. The purpose of this memorandum is to identify each element of the proposed compensation package that is potentially subject to Section 409A, to evaluate whether each element can be structured to be exempt from or in compliance with Section 409A, and to provide specific drafting recommendations for incorporation into the definitive Employment Agreement, Stock Option Award Agreement, and Restricted Stock Unit Award Agreement currently under preparation by this firm.
AHT is a privately held healthcare services and software-as-a-service ("SaaS") company that operates a cloud-based clinical workflow and revenue cycle management platform serving mid-market and large hospital systems, ambulatory surgical centers, and multispecialty physician groups across 32 states. The Company's equity ownership is distributed as follows: approximately 68% of outstanding equity is held by Ridgeline Capital Partners, LP ("Ridgeline"), a Boston-based private equity firm that acquired AHT in a take-private transaction in December 2019; approximately 14% is held by Helix Ventures Fund III, LP ("Helix Ventures"), an early-stage venture investor that retained its position through the take-private; and approximately 18% is held by management and other holders, including founders, employees, and certain former equity holders who rolled over their interests. AHT reported approximately $127.4 million in revenue for fiscal year 2021 and currently employs approximately 620 individuals across its Cambridge headquarters, its development center in Austin, Texas, and regional offices in Nashville, Tennessee and Denver, Colorado.
The specific compensation elements analyzed in this memorandum include the following:
(a) A stock option grant covering shares representing 1.25% of AHT's fully diluted equity, to be granted under the AHT 2020 Equity Incentive Plan (as amended May 2021);
(b) A restricted stock unit ("RSU") grant covering shares representing 0.50% of AHT's fully diluted equity, to be granted under the same equity plan;
(c) A one-time signing bonus of $250,000, payable within 30 days of Dr. Elliston's anticipated November 1, 2022 start date, subject to a 24-month clawback provision;
(d) An annual performance bonus with a target of 75% of Dr. Elliston's $575,000 annual base salary (i.e., a target annual bonus of $431,250), with a maximum payout of 150% of target (i.e., a maximum annual bonus of $646,875), based on the achievement of performance metrics to be established by the Company's Board of Directors (or a committee thereof); and
(e) Severance and change in control ("CIC") payments, including cash severance, accelerated equity vesting, continued health insurance coverage, and related benefits, payable upon termination without Cause or resignation for Good Reason, both outside and within the context of a change in control.
Summary Conclusion. Based on our analysis, and subject to the structuring recommendations set forth in this memorandum, each element of the proposed compensation package can be designed to either be exempt from Section 409A or comply with its requirements. Specifically, the stock option grant can be structured to fall within the stock rights exclusion of Treasury Regulation § 1.409A-1(b)(5); the RSU grant, signing bonus, and annual bonus can each be structured to qualify for the short-term deferral exemption of Treasury Regulation § 1.409A-1(b)(4); and the severance and change in control payments can be structured through a combination of the separation pay plan exemption of Treasury Regulation § 1.409A-1(b)(9), the short-term deferral exemption, and full compliance with Section 409A's permissible payment event, timing, and anti-acceleration rules. With these structuring modifications in place, the compensation package should avoid the adverse tax consequences imposed by Section 409A(a)(1), which include a 20% additional income tax on amounts includible in income, a premium interest penalty on the tax underpayment calculated from the date of the deferral, and accelerated inclusion in gross income of all deferred amounts to the extent not subject to a substantial risk of forfeiture.
Coordination with Outside Advisors. In preparing this memorandum, we have coordinated with Hargrove & Sinclair CPAs (Malcolm R. Sinclair, CPA, Lead Partner, 75 Ashbury Asset Advisors, Suite 1400, Boston, Massachusetts 02109) on valuation and computational matters relevant to the fair market value determination for the stock option exercise price and the RSU grant valuation, as well as on the Section 280G analysis being prepared separately. We have also coordinated with Sandra Okafor, Counsel in this firm's Corporate/M&A practice, who has reviewed the structural and governance provisions of the AHT 2020 Equity Incentive Plan (as amended May 2021) for compatibility with the proposed equity awards. The Section 280G/4999 excise tax analysis is the subject of a separate memorandum being prepared by the undersigned and Nadia Petrov, Senior Associate in our Tax practice, with an anticipated finalization date of September 2, 2022.
II. Background on Section 409A
A. Statutory Overview
Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 (Pub. L. 108-357, § 885) in response to perceived abuses in nonqualified deferred compensation arrangements, particularly those highlighted in connection with the Enron Corporation bankruptcy and related corporate scandals. Section 409A imposes comprehensive requirements on the design and administration of arrangements that provide for the deferral of compensation. The statute is broadly drafted and applies to virtually all forms of nonqualified deferred compensation, including supplemental executive retirement plans, nonqualified stock options (if improperly structured), phantom equity arrangements, bonus deferral programs, and severance agreements, among others.
The final Treasury regulations under Section 409A were published on April 17, 2007 (T.D. 9321, 72 Fed. Reg. 19,234), and became generally effective on January 1, 2009. Since that time, the Internal Revenue Service ("IRS") has issued additional guidance through notices, revenue rulings, and informal guidance, including Notice 2010-6 (providing limited correction procedures for certain 409A failures), Notice 2010-80 (addressing in-kind benefits and reimbursements), and proposed regulations on the definition of "service recipient stock" (REG-148326-05). The regulations are extensive and highly technical, and compliance requires careful attention to drafting, administration, and documentation.
B. Key Substantive Requirements
Section 409A imposes three principal sets of requirements on nonqualified deferred compensation arrangements:
Permissible Payment Events. Amounts of deferred compensation may be paid only upon the occurrence of one or more of the following six permissible payment events specified in Section 409A(a)(2)(A): (i) separation from service (as defined in Treasury Regulation § 1.409A-1(h)); (ii) the date the participant becomes disabled (as defined in Treasury Regulation § 1.409A-3(i)(4)); (iii) death; (iv) a specified time or pursuant to a fixed schedule; (v) a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation (each, a "change in control event" as defined in Treasury Regulation § 1.409A-3(i)(5)); or (vi) the occurrence of an unforeseeable emergency (as defined in Treasury Regulation § 1.409A-3(i)(3)). Payments made at any other time or for any other reason constitute impermissible early payments that violate Section 409A.
Initial Deferral Election Rules. Elections to defer compensation must generally be made no later than the close of the taxable year preceding the year in which the services giving rise to the compensation are performed. Section 409A(a)(4)(B). An exception applies for the first year of eligibility under a new plan or arrangement, in which case the election may be made within 30 days of the date the participant first becomes eligible, but only with respect to compensation attributable to services performed after the date of the election. Treasury Regulation § 1.409A-2(a)(7). Additional rules apply to performance-based compensation, fiscal year compensation, and certain other specific arrangements.
Subsequent Deferral Election and Anti-Acceleration Rules. Once a deferral election has been made (or, in the case of an employer-established payment schedule, once the payment schedule has been set), changes to the time and form of payment are strictly limited. A subsequent deferral election is permitted only if: (i) the new election is made at least 12 months before the date the payment was originally scheduled; (ii) the new election delays the payment by at least five years from the originally scheduled payment date; and (iii) if the payment event is a specified time or fixed schedule, the new election is not effective for 12 months. Section 409A(a)(4)(C). Separately, Section 409A(a)(3) and Treasury Regulation § 1.409A-3(j) prohibit the acceleration of any payment of deferred compensation, subject to limited exceptions (e.g., payment of employment taxes, domestic relations orders, conflicts of interest, de minimis cashouts).
C. Consequences of Noncompliance
The consequences of failing to comply with Section 409A are severe and are imposed on the service provider (i.e., Dr. Elliston), not on the service recipient (i.e., AHT). Specifically, Section 409A(a)(1) provides that if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of Section 409A(a), or is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. In addition to this accelerated income inclusion, the service provider is subject to: (i) an additional tax equal to 20% of the compensation required to be included in income; and (ii) a premium interest penalty calculated at the underpayment rate plus one percentage point, applied from the date the compensation was first deferred (or, if later, the date it was no longer subject to a substantial risk of forfeiture). These penalties can be financially devastating for senior executives with significant deferred compensation balances, and they cannot be grossed up or indemnified by the employer without creating additional 409A complications.
D. Exemptions from Section 409A
Critically, not all forms of compensation constitute "deferred compensation" for purposes of Section 409A. The Treasury regulations provide several important exemptions, and arrangements should be structured to fall within these exemptions wherever possible. The most commonly applicable exemptions include the following:
Short-Term Deferral Rule. Treasury Regulation § 1.409A-1(b)(4) provides that a payment is not treated as deferred compensation if it is paid by the 15th day of the third month following the later of (i) the end of the service provider's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture, or (ii) the end of the service recipient's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture (the "short-term deferral period"). This is the most commonly used exemption and is available for bonuses, equity awards settled promptly upon vesting, signing bonuses, and similar arrangements.
Stock Rights Exclusion. Treasury Regulation § 1.409A-1(b)(5) provides that certain stock options and stock appreciation rights ("SARs") are not treated as deferred compensation, provided they meet specific conditions relating to exercise price, the nature of the underlying stock, and the absence of deferral features. This exclusion is analyzed in detail in Section III below.
Separation Pay Exemptions. Treasury Regulation § 1.409A-1(b)(9) provides several exemptions for separation pay arrangements, including the "two-times pay" exemption (§ 1.409A-1(b)(9)(iii)) and the involuntary separation pay exemption (§ 1.409A-1(b)(9)(iii)), which are analyzed in Sections VII and VIII below.
E. Relevance of AHT's Private Company Status
AHT's current status as a privately held corporation (not publicly traded on an established securities market or otherwise) is relevant to several provisions of Section 409A and the Treasury regulations. Most notably, the "specified employee" rule of Section 409A(a)(2)(B)(i), which requires a six-month delay in separation-from-service payments to certain key employees, applies only to service recipients any stock of which is publicly traded on an established securities market or otherwise. Because AHT is currently privately held, the specified employee delay rule does not presently apply to payments under Dr. Elliston's compensation package. However, as discussed in Section IV.E below, if AHT were to undertake an initial public offering ("IPO") or become publicly traded through any other means during the term of Dr. Elliston's employment, the specified employee rule would become operative, and protective provisions should be included in the governing agreements to address this contingency. Additionally, the fair market value determination for stock option exercise prices is subject to specific rules for privately held companies, as discussed in Section III.C below.
III. Analysis of Stock Option Grant
A. Description of Proposed Grant
The proposed compensation package includes a grant of nonqualified stock options ("NQSOs") to Dr. Elliston to purchase shares of AHT common stock representing 1.25% of the Company's fully diluted equity. The options would be granted under the AHT 2020 Equity Incentive Plan, as amended in May 2021 (the "Equity Plan"), and would be governed by a Stock Option Award Agreement between AHT and Dr. Elliston. As currently proposed, the stock options would be subject to the following terms:
•  Vesting Schedule: 25% cliff vesting at 12 months from the grant date, with monthly vesting of the remaining 75% over the subsequent 36 months, resulting in a four-year total vesting period;
•  Exercise Price: To be set at the fair market value ("FMV") of AHT common stock as of the grant date;
•  Expiration: Ten years from the grant date (subject to earlier termination upon separation from service, as specified in the Equity Plan and Stock Option Award Agreement); and
•  Exercise Mechanism: The option may be exercised, in whole or in part, with respect to vested shares, by delivery of an exercise notice and payment of the aggregate exercise price and applicable tax withholding amounts.
Sandra Okafor, Counsel in the Corporate/M&A practice of this firm, has reviewed the structural and governance terms of the Equity Plan for compatibility with the proposed stock option grant and has confirmed that the plan contains sufficient share authorization and administrative provisions to support the grant. The draft Stock Option Award Agreement was prepared on August 12, 2022, and is currently under review by both Sandra Okafor and the undersigned for Section 409A compliance purposes.
B. Stock Rights Exclusion Under Treasury Regulation § 1.409A-1(b)(5)
Nonqualified stock options are generally exempt from Section 409A under the "stock rights" exclusion set forth in Treasury Regulation § 1.409A-1(b)(5)(i). Under this exclusion, the grant of a stock option does not constitute a deferral of compensation for purposes of Section 409A, and the option is therefore not subject to Section 409A's substantive requirements, provided that four conditions are satisfied:
(i) Exercise Price at or Above FMV. The option must be granted with an exercise price that may never be less than the fair market value of the underlying stock on the date of grant. Treasury Regulation § 1.409A-1(b)(5)(i)(A). If the exercise price is set below FMV (i.e., the option is "Discounted" or "in the money" at grant), the option constitutes deferred compensation subject to Section 409A from the date of grant. This requirement is a bright-line rule — even a minimal discount (e.g., an exercise price set at $9.95 when FMV is $10.00) will cause the option to fail the stock rights exclusion and become subject to Section 409A in its entirety. Notably, the exercise price must never be less than FMV, meaning that an exercise price set above FMV (a "premium" option) satisfies this requirement.
(ii) Service Recipient Stock. The option must cover "service recipient stock" within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii). Generally, this means common stock of the corporation for which the service provider performs services (or the direct or indirect parent corporation thereof). The service recipient stock requirement is discussed in greater detail in Section III.D below.
(iii) No Deferral Feature. The option must not include any feature for the deferral of compensation beyond the date of exercise and receipt of the underlying shares (or cash equivalent). Treasury Regulation § 1.409A-1(b)(5)(i)(C). This means that the option agreement may not permit the holder to exercise the option and elect to receive the shares at a later date, and may not provide for automatic deferral of share delivery following exercise. The prohibition on deferral features is discussed in Section III.E below.
(iv) Subject to Section 83 Taxation. The stock acquired upon exercise of the option must be subject to taxation under Section 83 of the Code. Treasury Regulation § 1.409A-1(b)(5)(i)(A). This requirement is generally satisfied for options granted to employees and is not expected to present any issue for Dr. Elliston's options.
If all four conditions are met, the stock option is fully exempt from Section 409A for the entirety of its term, from grant through exercise, and no Section 409A compliance provisions need to be incorporated into the Stock Option Award Agreement (though including a general 409A savings clause is nonetheless recommended as a matter of best practice).
C. Fair Market Value Determination — Section 409A Valuation Requirements
The most critical compliance element for the stock option grant is ensuring that the exercise price is set at or above the FMV of AHT common stock on the date of grant. Because AHT is a privately held company whose stock is not traded on an established securities market, FMV cannot be determined by reference to market trading prices. Instead, Treasury Regulation § 1.409A-1(b)(5)(iv)(B) provides that FMV must be determined by the "reasonable application of a reasonable valuation method." The regulations identify several factors that are relevant to whether a valuation method is reasonable, including the value of tangible and intangible assets, the present value of anticipated future cash flows, the market value of stock or equity interests in similar corporations engaged in similar trades or businesses, the value of recent arm's-length transactions involving the sale or transfer of the stock, control premiums or discounts for lack of marketability, and the consistency with which the valuation method is applied.
The Treasury regulations provide three safe harbor valuation methods that, if used, create a presumption that the valuation is reasonable. The burden of proof shifts to the IRS to demonstrate that the valuation is "grossly unreasonable." The three safe harbors are:
(1) Independent Appraisal Safe Harbor. A valuation performed by a qualified independent appraiser (as defined in Section 170(a)(1) and the regulations thereunder), provided the appraisal is conducted no more than 12 months before the relevant grant date. Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(i). This is the most commonly used safe harbor for established private companies and is the method we recommend for AHT.
(2) Formula-Based Valuation Safe Harbor. A valuation determined pursuant to a formula that is used consistently for all compensatory and noncompensatory purposes that require valuation of the stock (e.g., the same formula is used in buy-sell agreements, shareholder agreements, and regulatory filings). Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(ii). This safe harbor is available only if the formula is used consistently for all such purposes, which may be difficult to satisfy if AHT uses different valuation methodologies in different contexts (e.g., a different methodology for the Ridgeline Capital Partners Stockholders' Agreement repurchase provisions than for equity compensation grants).
(3) Start-Up Company Safe Harbor. A valuation performed by a person or persons with significant knowledge and experience in performing valuations of similar companies, applied to an "eligible start-up" — generally, a company that (a) has been in active trade or business for less than 10 years, (b) has no class of equity securities traded on an established securities market, and (c) does not reasonably anticipate a change in control event within 12 months or an IPO within 180 days. Treasury Regulation § 1.409A-1(b)(5)(iv)(B)(2)(iii). This safe harbor is likely inapplicable to AHT given the Company's $127.4 million in fiscal year 2021 revenue, approximately 620 employees, and operational maturity. AHT does not appear to qualify as an "eligible start-up" within the meaning of the regulation.
Recommendation. AHT should obtain an independent 409A valuation (commonly referred to in practice as a "409A valuation" or "fair market value appraisal") from a qualified independent appraiser prior to the date on which the stock options are granted to Dr. Elliston. The valuation should be coordinated through AHT's internal finance team, specifically Derek Solano, Chief Financial Officer, and with the assistance of Hargrove & Sinclair CPAs (Malcolm R. Sinclair, CPA, Lead Partner). The independent appraisal should employ methodologies appropriate for a private SaaS/healthcare services company of AHT's size and profile, which would typically include a combination of (a) a discounted cash flow analysis, (b) a comparable public company analysis (using publicly traded SaaS and healthcare IT companies as comparables), and (c) a comparable transaction analysis (referencing recent private market transactions in the healthcare SaaS sector).
We note that AHT's December 2019 take-private by Ridgeline Capital Partners, completed at an enterprise value of approximately $340 million, provides a useful historical reference point for understanding the Company's valuation trajectory. However, a current independent appraisal is essential given the more than two-and-a-half years that have elapsed since the take-private, during which AHT has experienced significant revenue growth, expansion of its product platform, and changes in market conditions (both favorable and unfavorable) for healthcare SaaS companies. Reliance on the 2019 take-private valuation alone would not constitute a reasonable valuation method under the Treasury regulations.
Additionally, the AHT 2020 Equity Incentive Plan (as amended May 2021) should contain — or be amended to contain — language requiring that the exercise price of any nonqualified stock option granted under the plan shall not be set below the FMV of the underlying stock on the date of grant, as determined in compliance with Section 409A and the Treasury regulations thereunder. We understand that the current version of the Equity Plan contains a general provision to this effect, but we recommend that Sandra Okafor confirm the adequacy of this language and propose any necessary amendments.
D. Service Recipient Stock Requirement
The stock underlying the option must constitute "service recipient stock" within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii). Service recipient stock is defined as common stock of the "eligible issuer of service recipient stock," which is the corporation for which the service provider performs services (or the corporation that is the direct or indirect majority owner thereof). For purposes of this rule, the determination of the direct or indirect majority owner is made by applying the rules of Section 414(b) and (c) (relating to controlled groups and affiliated service groups), substituting "at least 50 percent" for "at least 80 percent."
AHT is a Delaware corporation and Dr. Elliston would be providing services directly to AHT (and not to a subsidiary or affiliate). Accordingly, AHT common stock is the service recipient stock for purposes of this analysis. The proposed options would be granted on shares of AHT common stock, which satisfies this requirement. We note that the service recipient stock rules require that the stock be common stock — preferred stock, debt instruments, and phantom equity arrangements do not qualify. The AHT common stock that is the subject of the proposed option grant appears to satisfy this requirement, but the following additional considerations should be confirmed:
•  The Ridgeline Capital Partners Stockholders' Agreement (to which AHT is a party) should be reviewed to confirm that there is no arrangement, understanding, or side agreement that would cause the options to be treated as options on stock of a subsidiary, parent, or other entity rather than on AHT common stock. In particular, if Ridgeline has established a blocker entity or other intermediate holding structure between its fund and AHT, the service recipient stock analysis should confirm that AHT (rather than the blocker entity) is the appropriate eligible issuer of service recipient stock.
•  The Helix Ventures Fund III, LP stockholder provisions, including any anti-dilution protections, preemptive rights, and consent provisions applicable to the issuance of equity under the Equity Plan, should be reviewed to confirm that they do not create features or conditions that would compromise the stock rights exclusion. For example, if the Helix Ventures stockholder rights include a provision granting Helix Ventures a right to acquire shares from option holders upon exercise (a "call right" or "right of first refusal"), this provision should be evaluated to confirm that it does not constitute a deferral feature or otherwise impair the stock rights exclusion.
Preliminary Conclusion. Based on our preliminary review, and subject to confirmation of the foregoing items, the proposed options would be granted on AHT common stock that constitutes service recipient stock within the meaning of Treasury Regulation § 1.409A-1(b)(5)(iii), thereby satisfying this element of the stock rights exclusion.
E. Prohibition on Deferral Features
The stock rights exclusion requires that the option not include any "feature for the deferral of compensation" beyond the date of exercise. Treasury Regulation § 1.409A-1(b)(5)(i)(C). A deferral feature includes any provision that would permit the holder, upon exercise, to receive something other than the underlying stock (or cash equal to the fair market value of the stock at the time of exercise) within a reasonable period following exercise. Examples of deferral features that would disqualify an option from the stock rights exclusion include:
•  A provision permitting the holder to elect to receive shares at a date later than the exercise date (e.g., a "deferred delivery" election);
•  A "net settlement" or "net exercise" feature that is structured in a manner that provides the holder with the spread value in a form other than the immediate delivery of shares (though certain net exercise features may be permissible if properly structured to result in the delivery of shares on the exercise date);
•  A provision permitting the holder to receive the spread value in installments following exercise; and
•  Any "tandem" feature linking the option to a deferred compensation arrangement (e.g., an option that converts into a deferred compensation obligation upon the occurrence of a specified event).
Recommendation. The draft Stock Option Award Agreement (prepared August 12, 2022) should be carefully reviewed to confirm that it does not include any deferral feature. Specifically, the agreement should provide that, upon exercise, the Company shall deliver the shares of AHT common stock to the option holder promptly following exercise, and in all events no later than the end of the calendar year in which the exercise occurs or, if later, within two and one-half months following the date of exercise. This latter timing provision is consistent with the short-term deferral rule under Treasury Regulation § 1.409A-1(b)(4) and provides a backup exemption from Section 409A in the event that the stock rights exclusion is determined not to apply for any reason. The agreement should also include an express representation that the option does not include any feature for the deferral of compensation beyond the date of exercise, other than the period reasonably necessary to accomplish the administrative delivery of shares.
F. Conclusion on Stock Options
If the proposed stock option grant is structured in accordance with the foregoing requirements — specifically, (i) the exercise price is set at or above the FMV of AHT common stock on the grant date, as determined by a qualified independent appraisal; (ii) the options cover AHT common stock that constitutes service recipient stock; (iii) the Stock Option Award Agreement does not include any feature for the deferral of compensation beyond exercise and payment; and (iv) the stock acquired upon exercise is subject to taxation under Section 83 — then the proposed stock option grant should be fully exempt from Section 409A under the stock rights exclusion of Treasury Regulation § 1.409A-1(b)(5). No Section 409A compliance provisions (such as permissible payment event restrictions, specified employee delays, or anti-acceleration provisions) would be required with respect to the options, though we recommend including a general Section 409A savings clause as a matter of best practice.
IV. Analysis of Restricted Stock Unit (RSU) Grant
A. Description of Proposed Grant
The proposed compensation package includes a grant of restricted stock units ("RSUs") covering shares of AHT common stock representing 0.50% of the Company's fully diluted equity. The RSUs would be granted under the AHT 2020 Equity Incentive Plan (as amended May 2021) and would be governed by a Restricted Stock Unit Award Agreement between AHT and Dr. Elliston. As currently proposed, the RSUs would be subject to the following terms:
•  Vesting Schedule: 33.33% vesting annually over a three-year period from the date of grant, with each tranche vesting on the applicable anniversary of the grant date;
•  Settlement: Shares of AHT common stock to be delivered upon each vesting date (i.e., mandatory settlement upon vesting, as currently drafted); and
•  Change in Control Acceleration: Full acceleration of all unvested RSUs upon a qualifying termination (termination without Cause or resignation for Good Reason) occurring within 24 months following a change in control of the Company (commonly referred to as a "double-trigger" acceleration provision).
B. RSUs Are Potentially Subject to Section 409A
Unlike stock options that meet the stock rights exclusion described in Section III above, RSUs do not benefit from a specific statutory or regulatory exclusion from Section 409A. This is because RSUs represent a contractual promise by the employer to deliver shares of stock (or a cash equivalent) at a future date, contingent upon the satisfaction of vesting conditions. Unlike a stock option, which requires the service provider to pay an exercise price in order to acquire shares, an RSU entitles the holder to receive shares (or cash) without any additional payment. As a result, an RSU is functionally a promise to deliver property at a future date and is generally treated as a "deferral of compensation" within the meaning of Section 409A, unless the RSU qualifies for an available exemption.
The most commonly applicable exemption for RSUs is the short-term deferral rule under Treasury Regulation § 1.409A-1(b)(4), which is available if the shares are delivered within a specified period following the lapse of the substantial risk of forfeiture (i.e., vesting). If the RSUs do not qualify for the short-term deferral exemption — for example, because the RSU agreement provides for settlement at a date significantly later than the vesting date — then the RSUs constitute deferred compensation fully subject to Section 409A, and all of Section 409A's substantive requirements (permissible payment events, anti-acceleration, specified employee delay, etc.) must be satisfied.
C. Short-Term Deferral Exemption — Treasury Regulation § 1.409A-1(b)(4)
Under the short-term deferral rule, a payment is not treated as a deferral of compensation subject to Section 409A if the payment is made by the 15th day of the third month following the later of: (i) the end of the service provider's taxable year in which the right to the payment is no longer subject to a "substantial risk of forfeiture" (as defined in Treasury Regulation § 1.409A-1(d)), or (ii) the end of the service recipient's taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. For RSUs, the "substantial risk of forfeiture" generally lapses on the applicable vesting date, at which point the participant has an unconditional right to receive the shares.
Practical Application. AHT's taxable year is the calendar year, and Dr. Elliston's taxable year is also the calendar year (as is the case for virtually all individual taxpayers). Accordingly, for each tranche of RSUs that vests on a given anniversary of the grant date, the short-term deferral period extends through March 15 of the calendar year following the year of vesting. By way of example, if the grant date is November 15, 2022:
•  Tranche 1 (33.33%): Vests on November 15, 2023. Short-term deferral period ends March 15, 2024. Shares must be delivered by March 15, 2024.
•  Tranche 2 (33.33%): Vests on November 15, 2024. Short-term deferral period ends March 15, 2025. Shares must be delivered by March 15, 2025.
•  Tranche 3 (33.34%): Vests on November 15, 2025. Short-term deferral period ends March 15, 2026. Shares must be delivered by March 15, 2026.
Recommendation. The RSU Award Agreement should be drafted to require mandatory settlement (i.e., delivery of shares of AHT common stock) within the short-term deferral window following each vesting date. Specifically, we recommend that the agreement provide that settlement shall occur within 60 days following each applicable vesting date, and in no event later than March 15 of the calendar year following the calendar year in which the applicable vesting date occurs. The 60-day settlement window provides AHT with administrative flexibility to process the settlement and arrange for share delivery and tax withholding, while the March 15 outside date ensures that the short-term deferral exemption is preserved even if administrative delays occur.
The draft RSU Award Agreement (prepared August 12, 2022, reviewed by Sandra Okafor and the undersigned) should be reviewed to confirm that it incorporates these settlement timing provisions. In particular, the draft should be reviewed to confirm that there is no provision permitting Dr. Elliston to elect to defer settlement beyond the short-term deferral period, and no provision permitting AHT to unilaterally defer settlement beyond the short-term deferral period. Any such provision would cause the RSUs to constitute deferred compensation fully subject to Section 409A.
D. Change in Control Acceleration — Section 409A Implications
The proposed RSU award includes a double-trigger acceleration provision: full acceleration of all unvested RSUs upon a qualifying termination (termination without Cause or resignation for Good Reason) occurring within 24 months following a change in control of the Company. This provision raises several Section 409A considerations.
Acceleration of Vesting Distinguished from Acceleration of Payment. As an initial matter, the acceleration of vesting itself is not a Section 409A issue. The anti-acceleration rule of Section 409A(a)(3) prohibits the acceleration of the time or schedule of any payment of deferred compensation, but does not prohibit the acceleration of vesting (i.e., the removal of a substantial risk of forfeiture). The distinction is critical: when RSU vesting is accelerated, the substantial risk of forfeiture is removed earlier than originally scheduled, but the payment (i.e., the delivery of shares) can still occur within the short-term deferral period following the new, earlier vesting date. Provided that settlement occurs within the short-term deferral window following the accelerated vesting date, the RSUs remain within the short-term deferral exemption and Section 409A is not implicated. Treasury Regulation § 1.409A-3(j)(1) (anti-acceleration rule does not apply to amounts that are not "deferred compensation" because they satisfy the short-term deferral exemption).
Change in Control Definition Conformity. Although the acceleration of RSU vesting upon a change in control does not itself trigger Section 409A concerns (provided settlement occurs within the short-term deferral period), the definition of "change in control" used in the Employment Agreement and RSU Award Agreement is nonetheless important and should be evaluated for conformity with Section 409A. This is because the same definition of "change in control" is used to trigger the enhanced severance payments under the Employment Agreement (discussed in Section VIII below), which do constitute deferred compensation subject to Section 409A.
The proposed Employment Agreement defines "change in control" as follows:
(i) The acquisition of more than 50% of the outstanding voting securities of AHT by any person or group of affiliated persons (other than Ridgeline Capital Partners, LP or its affiliates);
(ii) The consummation of a merger, consolidation, or sale of all or substantially all of the assets of AHT, in which the existing stockholders of AHT retain less than 50% of the voting power of the surviving or acquiring entity;
(iii) The complete liquidation or dissolution of AHT; and
(iv) A change in the majority composition of the Board of Directors of AHT (other than changes approved by a majority of the incumbent Board).
This definition must be evaluated against the three categories of Section 409A-compliant change in control events set forth in Treasury Regulation § 1.409A-3(i)(5):
(a) Change in ownership of a corporation. A change in the ownership of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, together with stock held by such person or group, constitutes more than 50% of the total fair market value or total voting power of the stock of such corporation. Treasury Regulation § 1.409A-3(i)(5)(v). The proposed definition's trigger (i) is broadly consistent with this category, subject to the Ridgeline carve-out discussed below.
(b) Change in effective control of a corporation. A change in the effective control of a corporation occurs on the date that (I) any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 30% or more of the total voting power, or (II) a majority of the members of the Board of Directors is replaced during any 12-month period by directors whose appointment or election is not endorsed by a majority of the members of the Board of Directors prior to the date of the appointment or election. Treasury Regulation § 1.409A-3(i)(5)(vi). The proposed definition's trigger (iv) is broadly consistent with the Board replacement prong of this category.
(c) Change in ownership of a substantial portion of the assets of a corporation. A change in the ownership of a substantial portion of the assets of a corporation occurs on the date that any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the corporation that have a total gross fair market value equal to or more than 40% of the total gross fair market value of all of the assets of the corporation immediately prior to such acquisition or acquisitions. Treasury Regulation § 1.409A-3(i)(5)(vii). The proposed definition's trigger (ii) (merger, consolidation, or sale of substantially all assets) is broadly consistent with this category, and trigger (iii) (complete liquidation or dissolution) may also fall within this category depending on the circumstances.
Ridgeline Capital Partners Carve-Out. The proposed definition excludes from the definition of "change in control" any acquisition of AHT voting securities by Ridgeline Capital Partners, LP or its affiliates. This carve-out is permissible under Section 409A, because the Treasury regulations permit the contractual definition of "change in control" to be narrower than the regulatory definition. The regulations do not require that every transaction meeting the regulatory definition of a change in control event trigger a payment; they require only that no payment be triggered by an event that does not meet the regulatory definition. Accordingly, the Ridgeline carve-out (which narrows the range of transactions that constitute a change in control under the Employment Agreement) does not create a Section 409A compliance issue, so long as the remaining triggers in the contractual definition are congruent with or narrower than the corresponding categories under Treasury Regulation § 1.409A-3(i)(5).
Recommendation. We recommend that the following steps be taken with respect to the change in control definition:
(i) Include a provision in both the Employment Agreement and the RSU Award Agreement stating that, to the extent any payment or benefit constitutes "nonqualified deferred compensation" within the meaning of Section 409A, a "change in control" shall not be deemed to have occurred unless such event also constitutes a "change in control event" within the meaning of Treasury Regulation § 1.409A-3(i)(5). This "409A overlay" provision ensures that any deferred compensation payment triggered by a change in control will satisfy Section 409A's permissible payment event requirement.
(ii) If the RSUs remain within the short-term deferral exemption (which they should, provided settlement occurs within the short-term deferral window following any accelerated vesting), the conforming change in control definition is less critical for the RSUs themselves. However, the conforming definition remains critical for the severance payments discussed in Sections VII and VIII below, and including the provision in the RSU Award Agreement as well provides an additional layer of protection and consistency across the compensation package.
E. Specified Employee Rule — Contingency Planning if AHT Goes Public
Section 409A(a)(2)(B)(i) provides that, in the case of any "specified employee" (as defined in Section 409A(a)(2)(B)(ii)), distributions of nonqualified deferred compensation that are payable on account of separation from service shall not be made before the date that is six months after the date of separation from service (or, if earlier, the date of death). This six-month delay requirement applies only to service recipients whose stock is "publicly traded on an established securities market or otherwise." Section 409A(a)(2)(B)(i)(I). A "specified employee" is generally a key employee of the service recipient, as determined under the rules of Section 416(i) — typically, an officer with annual compensation exceeding a specified threshold ($200,000 for 2022), a five-percent owner, or a one-percent owner with annual compensation exceeding $150,000.
AHT is currently a privately held corporation whose stock is not publicly traded on an established securities market or otherwise. Accordingly, the specified employee delay rule does not currently apply to payments under Dr. Elliston's compensation package. This means that, under current circumstances, any separation-from-service payments that constitute deferred compensation under Section 409A may be made to Dr. Elliston upon separation from service without a six-month delay, regardless of his status as a key employee.
However, if AHT were to undertake an IPO, a SPAC transaction, a direct listing, or any other transaction that results in AHT's stock (or the stock of a parent or successor entity) becoming publicly traded during the term of Dr. Elliston's employment, the specified employee delay rule would become operative. Given Dr. Elliston's anticipated title (Chief Operating Officer) and compensation level (annual base salary of $575,000 plus bonus), he would almost certainly qualify as a "specified employee" under Section 416(i) in the event AHT becomes publicly traded. In that scenario, if any RSU settlement were triggered by Dr. Elliston's separation from service and constituted deferred compensation under Section 409A (i.e., did not qualify for the short-term deferral exemption because of a delayed settlement provision or administrative failure), the settlement would need to be delayed for six months following separation from service.
Recommendation. As a "belt-and-suspenders" protective measure, we recommend including a provision in the RSU Award Agreement providing that, in the event AHT becomes a publicly traded company and the RSU settlement is triggered by separation from service and constitutes nonqualified deferred compensation within the meaning of Section 409A, settlement shall be delayed until the first business day following the six-month anniversary of the date of separation from service (or, if earlier, the date of Dr. Elliston's death). We recognize that if the short-term deferral exemption applies to the RSUs (as it should, given our recommended settlement timing provisions), the specified employee delay is unnecessary as a legal matter, because the short-term deferral exemption takes the RSUs entirely outside the scope of Section 409A. Nonetheless, including the protective language guards against the possibility that the short-term deferral exemption is later determined to be unavailable (e.g., due to an administrative failure to settle within the required window), and demonstrates good faith compliance with Section 409A in the event of an IRS examination.
F. Conclusion on RSUs
If the RSU settlement is structured to occur within the short-term deferral window following each vesting date — specifically, within 60 days following the applicable vesting date, and in no event later than March 15 of the calendar year following the calendar year of vesting — the RSUs should qualify for the short-term deferral exemption of Treasury Regulation § 1.409A-1(b)(4) and should be exempt from Section 409A. This analysis applies equally to the regularly scheduled vesting dates and to any accelerated vesting upon a qualifying termination within 24 months following a change in control, provided that settlement following accelerated vesting also occurs within the short-term deferral period. Protective specified employee delay language should be included in the RSU Award Agreement as a contingency for a potential future AHT public offering, as described in Section IV.E above.
V. Analysis of Signing Bonus with Clawback
A. Description.  The proposed compensation package includes a one-time signing bonus of $250,000, payable to Dr. Elliston within 30 days of his anticipated start date of November 1, 2022. The signing bonus is intended to serve as an inducement for Dr. Elliston to accept the COO position and to compensate him, in part, for compensation he will forfeit from his current employer upon resignation.
The signing bonus is subject to a 24-month clawback provision: if Dr. Elliston voluntarily resigns without Good Reason or is terminated by AHT for Cause within 24 months of his start date, he is required to repay the signing bonus. The specific terms of the clawback (whether repayment is pro-rata based on the number of months of service completed, or in full regardless of the timing of departure) are to be specified in the Employment Agreement and are currently under negotiation between AHT and Dr. Elliston's counsel, Catherine A. Fielding, Partner at Fielding & Rowe LLP.
B. Section 409A Analysis — Signing Bonus Payment
The signing bonus, as proposed, is not deferred compensation within the meaning of Section 409A because it is paid within the short-term deferral period. The analysis proceeds as follows:
The right to receive the signing bonus vests upon Dr. Elliston's commencement of employment with AHT, which is anticipated to occur on November 1, 2022. At that point, Dr. Elliston has a legally binding right to receive the $250,000 payment, and the substantial risk of forfeiture with respect to that right has lapsed. The short-term deferral period extends through the 15th day of the third month following the later of (i) the end of Dr. Elliston's taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture (December 31, 2022), and (ii) the end of AHT's taxable year in which the right is no longer subject to a substantial risk of forfeiture (December 31, 2022). Accordingly, the short-term deferral period for the signing bonus extends through March 15, 2023.
Payment of the signing bonus within 30 days of the November 1, 2022 start date (i.e., by approximately December 1, 2022) is well within the short-term deferral period of March 15, 2023. The signing bonus payment is therefore exempt from Section 409A under the short-term deferral rule of Treasury Regulation § 1.409A-1(b)(4).
Conclusion. The signing bonus payment, as currently structured, is exempt from Section 409A under the short-term deferral rule. No Section 409A compliance provisions are required with respect to the signing bonus payment itself.
C. Section 409A Analysis — Clawback Obligation
The 24-month clawback provision creates a repayment obligation — that is, an obligation for Dr. Elliston to return previously received compensation to AHT upon the occurrence of specified events (voluntary resignation or termination for Cause within 24 months). This repayment obligation is analytically distinct from a deferral of compensation.
Treasury guidance and IRS informal guidance indicate that a clawback or repayment obligation does not itself create a Section 409A deferral arrangement. The clawback operates as a separate contractual obligation, and the existence of the clawback does not convert the signing bonus from a current payment into a deferred payment. The IRS has not issued formal guidance directly addressing the Section 409A treatment of clawback provisions, but the consensus position among practitioners — supported by the structure of the Treasury regulations and informal IRS commentary — is that a clawback does not create deferred compensation, because the employee receives the payment currently and has immediate use of the funds; the clawback merely creates a contingent liability to return those funds in specified circumstances.
However, care must be taken to ensure that the clawback provision does not create a "substantial risk of forfeiture" that effectively extends the vesting period beyond the payment date, which could potentially recharacterize the arrangement. If the signing bonus were structured as a conditional payment — that is, a payment that is made but does not become "final" or "fully earned" until the expiration of the 24-month clawback period — an argument could be made that the substantial risk of forfeiture does not lapse until the end of the 24-month period. In that case, the payment made on the start date would be a prepayment of an amount that does not vest until 24 months later, and the arrangement could potentially be recharacterized as deferred compensation. While we believe this argument is unlikely to prevail if properly rebutted, the risk can be eliminated through proper drafting.
Recommendation. The signing bonus provision in the Employment Agreement should be drafted in two distinct parts:
(a) Unconditional Payment. The signing bonus should be described as an unconditional payment of $250,000 to be made within 30 days of Dr. Elliston's start date. The agreement should state that the signing bonus is fully earned upon commencement of employment and is payable without condition. The language should make clear that the payment is not contingent on continued employment and is not forfeitable.
(b) Separate Repayment Obligation. The clawback should be structured as a separate, independent contractual obligation to repay the signing bonus (or a pro-rata portion thereof) upon the occurrence of specified clawback events. The repayment obligation should be set forth in a separate section or paragraph from the payment provision, and should be drafted as a covenant of Dr. Elliston running in favor of AHT, rather than as a condition to the right to receive the payment.
This two-part structure clearly distinguishes the signing bonus from deferred compensation and eliminates any argument that the payment is conditional or subject to a substantial risk of forfeiture during the 24-month clawback period.
We note that Devon Archer has prepared a separate memorandum dated August 1, 2022, analyzing the enforceability of the clawback provision under the Massachusetts Wage Act (M.G.L. c. 149, § 148 et seq.) and related Massachusetts employment law. The Section 409A analysis and the Massachusetts Wage Act analysis are independent of each other, but both should be considered in finalizing the signing bonus provision.
VI. Analysis of Annual Bonus Compensation
A. Description.  The proposed compensation package includes eligibility for an annual performance bonus with the following parameters:
•  Target Bonus: 75% of Dr. Elliston's $575,000 annual base salary, yielding a target annual bonus of $431,250.
•  Maximum Bonus: 150% of the target bonus, yielding a maximum annual bonus of $646,875.
•  Performance Metrics: The bonus will be based on the achievement of individual and company-wide performance metrics to be established by the Board of Directors of AHT (or a committee thereof) at the beginning of each performance year. The specific metrics for fiscal year 2023 (the first full performance year) are currently under negotiation between AHT and Dr. Elliston's counsel at Fielding & Rowe LLP.
•  Payment Timing: To be determined and specified in the Employment Agreement. The typical practice for AHT's annual bonus program (per information provided by Aaron Whitfield) is to pay annual bonuses to senior executives in February or early March following the end of the performance year, after the Board has certified performance results.
B. Short-Term Deferral Exemption
Annual performance bonuses are one of the most common forms of compensation that can be structured to qualify for the short-term deferral exemption under Treasury Regulation § 1.409A-1(b)(4). The analysis is straightforward: the right to the annual bonus is generally subject to a "substantial risk of forfeiture" throughout the performance period, because the bonus is contingent upon the achievement of performance metrics that are not known until the end of the performance year (and, in many cases, are not certified until after the end of the performance year). The substantial risk of forfeiture lapses upon the determination that the performance conditions have been satisfied — generally, at the end of the performance year or upon the date the Board certifies performance results.
Under the short-term deferral rule, the bonus is exempt from Section 409A if it is paid by the 15th day of the third month following the later of (i) the end of Dr. Elliston's taxable year in which the bonus is earned (i.e., the performance year), and (ii) the end of AHT's taxable year in which the bonus is earned. Because both Dr. Elliston and AHT are calendar year taxpayers, and the performance period is the calendar year, the short-term deferral deadline is March 15 of the year following the performance year.
Recommendation. The Employment Agreement should specify that annual bonuses will be paid no later than March 15 of the calendar year following the performance year. This deadline should be expressed as an outside payment date that is binding on the Company, not merely a target or aspirational date. The relevant provision might read, for example: "Any annual bonus earned with respect to a performance year shall be paid no later than March 15 of the calendar year immediately following the end of such performance year." The use of a hard March 15 outside date, combined with the Company's existing practice of paying bonuses in February or early March, provides a comfortable margin within the short-term deferral window and ensures that the annual bonus is exempt from Section 409A.
C. Pro-Rata Bonus on Termination
The proposed severance provisions in the Employment Agreement include a pro-rata annual bonus for the year of termination, payable upon a qualifying termination (termination without Cause or resignation for Good Reason). The pro-rata bonus is to be calculated based on actual performance for the full performance year, pro-rated for the number of days Dr. Elliston was employed during the performance year prior to the date of termination.
This pro-rata termination bonus raises a specific Section 409A concern. If the pro-rata bonus is payable upon separation from service — that is, if separation from service is the payment trigger — rather than on the regular bonus payment schedule, the pro-rata bonus may constitute deferred compensation subject to Section 409A. This is because the right to the pro-rata bonus is conditioned on both (i) the achievement of performance metrics (which occurs at the end of the performance year) and (ii) a qualifying termination event. If the payment is triggered by the termination event and is made at a time earlier than the regular bonus payment date, the arrangement may not qualify for the short-term deferral exemption (because the vesting condition — satisfaction of performance metrics — may not have lapsed at the time of termination). Conversely, if the payment is triggered by the termination event but is made later than the short-term deferral window following the lapse of the performance condition, the arrangement is deferred compensation subject to Secti

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT

MEMORANDUM

Record

Parties

Dates

Amounts