409A Valuations: Understanding the Process & Managing Risk

Issuing stock options to employees can be a great way to reward and motivate good performance. In some cases, such stock options can also confer tax benefits. However, in order to ensure that appropriate taxes are paid on all deferred compensation and stock options, the IRS requires that private companies secure a valuation of these shares. 409A valuations are vital for every company to conduct properly—even early stage startups— in order to avoid serious penalties at a later date.

If you are considering issuing employee shares as a means of compensation, it’s important that you consult with a corporate lawyer and that your employees separately consult with tax lawyers. Priori can help connect you and your employees with lawyers to assist with the valuation process and help you avoid the significant costs sometimes associated with these transactions.

Understanding 409A Valuations

Under Section 409A of the Internal Revenue Code, private companies that issue nonqualified deferred compensation -- e.g. stock options, stock appreciation rights, qualified employer retirement plans, and other common employee grants of shares -- must correctly assess the value of this compensation. Such a fair market appraisal of the value of such shares is a 409A valuation. This valuation is then used as a basis of the stock options granted. 

When You Need One

When a private company issues employee stock options or other types of deferred compensation, there must be a fair valuation per IRS Section 409A. This is true regardless of the stage of your business; valuations are required of well-established companies and high-growth companies, just as they are required of seed stage startups. Importantly, 409A valuations must be updated any time that there is a material change event that could alter the value of the 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.

Safe Harbor Valuation Methods That Comply with IRS Section 409A

All 409A Valuations are expected to employ a reasonable application of a reasonable valuation method. While any valuation method that meets IRS standards could qualify, there are two approved safe harbor valuation methods that companies can use to comply with IRS Section 409A.

  • Independent Valuation

The most common way to safely comply with Section 409A is to hire an independent, outside qualified appraiser to do the valuation. The third-party appraiser must be allowed full access for an assessment and take into consideration all available information material to the valuation of the company’s common stock.

  • Illiquid Startup Inside Valuation

If a startup is not yet big enough or established enough to afford the costs of an independent valuation, an inside valuation may be acceptable. In order to qualify to rely on the illiquid startup insider valuation safe harbor method, a company must have:

  • Been in business for no more than ten years;

  • No publicly traded securities;

  • No reasonable expectation of being acquired in the next 90 days or going public within the next 180 days; and

  • No common stock subject to put or call rights or other similar obligations.

Factors in Determining a Fair Valuation Under 409A

No matter which safe harbor method your company chooses to determine the value of issued shares or deferred compensation, the basic factors involved will be the same. The following are some key considerations that must be accounted for in a valuation per IRS Section 409A:

  • all tangible and intangible assets of the company,

  • present and future cashflows,

  • market value of outstanding shares,

  • recent stock sales and transfers,

  • market position,

  • share prices of similar transactions, and

  • marketability of shares.

Risks of Undervaluation

Every company must ensure an accurate fair market value of its common stock as of the option grant date using this valuation criteria. Possible consequences of an inaccurate valuation under Section 409A of the Internal Revenue Code include:

  • a 20% federal penalty on the error,

  • IRS tax underpayment penalties plus an additional 1% premium underpayment penalty,

  • additional shareholder penalties when shares vest,

  • potential state fees, and

  • negative press and, if applicable, market response.

A Priori financing lawyer or attorney can help guide your business through the 409A valuation process. 

FAQ

How do 409A valuations apply to startups?

Many startups allocate stock options to key employees as a form of compensation, especially in the early stages of business. This kind of compensation triggers Section 409A, no matter how new a startup you are.

Does restricted stock fall under Section 409A?

No. Generally, only stock options are addressed under Section 409A. Most restricted stock, including the type generally granted to investors when raising capital, is not considered deferred compensation.

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