Stocks are a great reward for an employee, and theyíll typically be happy to receive them. In some cases, such stock options can also confer tax benefits. To ensure that taxes are being paid properly for deferred compensation and stock options, the IRS will require that any private company have a valuation of the shares. All companies, even young startups, should get 409A valuations to avoid future problems.
If you want to issue employee shares as part of their compensations then you should consult with a corporate lawyer and your employees a tax lawyer. Section 409A applies to all companies offering nonqualified deferred compensation plans to employees, including stock options, appreciation rights, qualified retirement plans and other employee grants. Before you can offer any 409A options youíre going to need a 409A valuation.
Why are 409A Valuations Important?
A 409A valuation is simply an appraisal of the fair market value of a companyís more common stocks. The 409A name comes from IRS Section 409A. Added in 2004 as a part of the American Jobs Creation Act is says:
ìSection 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.î
Stock options fall under the title of deferred compensation. A strike price, which is the price at which an employee is able to buy equity in your company, will also be determined by the 409A valuation.
When a private company issues an employee stock option or other types of deferred compensation, there must be a fair valuation per IRS Section 409A. It doesnít matter what type of business it is or what stage it is at, the requirement still stands. On top of this, you have to update your 409A valuation if there is a material change event which could alter the value of your stock. Material change events include receiving a term sheet for financing, receiving new financing, settling a lawsuit, or filing a patent. Valuations must also be updated based on elapsed time, even if there is no material change event. In general, in the absence of a material change event, a valuation is considered to be valid for just 12 months. After 12 months the company must be reevaluated. This is also the case whenever a company closes a new funding round.
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What Affects Your 409A Valuation?
IRS regulations state that fair market value may be determined through the reasonable application of a reasonable valuation method. Further explanation is that so long as a method is applied consistently and reasonable the valuation will be accepted. Consistency is based on how other methods are performed to determine fair market value for equity. An independent appraisal will be presumed reasonable if ìthe appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.î
In order to determine the 409A a firm will use one of the following approaches:
This approached is when you use the selling price of similar items to determine the value. This approach is a business valuation method that useful for calculation property value or as part of a valuation process for closely held businesses. As well, the market approach is able to help determine the value of a security, intangible asset, or a business ownership interest. This method takes all assets being considered and assesses their current value based on any recent sales of similar assets, taking into account the differences in quality, size, and quantity.
The market approach is prospective because it uses value measures based on the prices of publicly traded stocks and the prices of actual transactions for the purchase and sale of companies in a certain industry or similar industries. The expected future benefits from the association and shared ownership between vendors and purchasers will influence how both parties go about their operations.
In order to have an accurate valuation you should keep two questions in mind:
Are the comparable companies used as guidelines truly comparable to the company in question, or are there better examples to compare and contrast with?
Are the correct multiples being taken from the stock market and being applied to the parameters of the company in question?
The income approach is a real estate appraisal method that allows investors to estimate the value of a property by taking the net operating income (NOI) of the rent collected and dividing it by the capitalization rate. When determining the propertyís net operating income an investor uses market sales of comparable properties for choosing a capitalization rate.
After determining a capitalization rate, the investor adjusts the rate based on the propertyís characteristics. One example would be if the tenants are of a higher quality than those around it then the rate would go down. On the flip side, a property that looks a bit worse than the others will receive a higher rate. The rate should end up within 50 points of the average on the market.
The income approach is typically used for income-producing properties and is one of three popular approaches to appraising real estate. The others are the cost approach and the comparison approach.
The income approach looks to see if a return of investment can be done by the business having a steady enough cash flow from its operations. This approach will capitalize or discount the estimated future maintainable after-tax cash flow from operations by a rate of return. This will allow future potential property buyers to understand their risks in buying this property based on its inherent ability to produce income, especially as compared to the amount of investment they may need to make.
The two variables that are used in this method above others are the future cash flow and the risk taken to earn that cash flow back. Youíll receive a much better 409A if youíre able to care for these variables.
This approach determines the cost of recreating the business based on its net asset value (NAV), which is the total assets minus the total liabilities. There are multiple ways to interpret this number a there is some discrepancy in deciding whatís an asset, whatís a liability, and how much those items are worth.
The conclusions made will affect the net tangible assets, and thusly the overall business value, as that is a key factor in deciding it. Buyers may become interested in a company because of its availability vs. security with regards to financing of it, or they might view the risk of something like bankruptcy to be easily handled due to the large amount of physical assets which can be liquidized.
What do I need to do to get a 409A Valuation?
There are three options available to receive a 409A valuation report:
Work with a firm: Most people end up using this method as itís a safe one. It shifts the burden of proof onto the IRS in order to determine your 409Aís value. If itís overly high or low then the IRS will be forced to continue to back it. Itís the most expensive option, but with the right knowledge and a reputable firm backing you, it will pay off.
Use a Program: This choice is a bit risky. Early stage startups can use this method, as some of the criteria for being allowed to use it include not having raised $500,000, not be within 180 days of an IPO, and not within 90 days of an acquisition, all of which you must be able to prove.
Do it on Your own: Youíre taking the most risks by going with this method. There are no safe harbors for you should you make a mistake. Sure initially you can save some money, but when the IRS decides your valuation needs some reevaluation youíre going to be paying a whole lot more. Itís highly recommended to leave it to the professionals, or to at least be very knowledgeable on the subject of 409A valuations.
Common mistakes made with 409A valuations:
Hiring an appraiser who is inexperienced. A cheaper firm does not equal a good service. Ensure the firm you hire has a good reputation.
Choosing an appraiser before you get input from the company accountants. If the IRS performs an audit, they will need to work closely with your accountants, so keeping them in the know is key.
Putting pressure on the appraiser. You may want them to come back with a lower strike price, but the appraiser can refuse to issue the 409A valuation report or refuse to defend the valuation if the IRS performs an audit of the company. Itís best you donít let your relationship fall on bad terms.
Will I have to wait long for my 409A Valuation?
Due to the number of various factors itís hard to put an expect time for the return of a 409A valuation. However, you can generally expect the following time frame:
Hand over your data (1-3 days): This includes your articles of incorporation, cap table, financial projections, past 409A reports, and financial projections.
Running the report (10-20 days): If you require a quicker valuation then you can expect to pay a minimum of $1,000.
Necessary revisions are done (1-2 days).
Final report is delivered (1-10 days).
At the worst it may take just over a month for you to get all of the needed information put together and get a finished 409A valuation back. However, if there are errors or the IRS has to get involved then this may take even longer. You can minimize your errors and, thusly, pick up the pace of the process by hiring a firm. Youíll need to be accurate for the time frame.
What Can Happen if I donít have a 409A Valuation?
Basically, youíve got a nightmare to have to deal with. If you donít price your stock options, the IRS treats it as though the company is just giving away assets. If an option holder is found to be violating 409A then theyíll have to pay IRS tax underpayment penalties, unpaid taxes, state penalties, and the interest on unpaid taxes. Under Section 409A all service recipients will be responsible for the regular withholding and reporting obligations as related to the includible amounts found in the service providerís gross income. Anyone that is holding stock options will find themselves extremely irritated by this, since theyíll be unable to pay the taxes and interest if there is an absence in the exercise of the option and the sale of the underlying stocks.