Stocks are a good way to motivate and reward employees, as theyíll often be happy to take them. Sometimes they can even 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.
Anyone who is considering offering shares to employees as a form of compensation should first speak with a corporate lawyer while the employees each speak with their own 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. Itís important to know where you stand by getting a 409A valuation before you can begin to offer 409A.
What is a 409A Valuation?
409A valuations are appraisals of the current fair market value of a companyís common stocks. The IRS Section 409A is where this valuation gets its name from. The section, added with the American Jobs Creation Act in 2004, states:
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 409A valuation will determine a “strike price” (the price at which your employees can buy equity in your company) that must be at or above fair market value.
Private companies that offer employee stock options or any other deferred compensation must have a fair valuation, as per the IRS Section 409A. It doesnít matter if the business is a startup or a company like Amazon; it is required all the same. As well if any material change event should occur, since it could alter the stockís value, then a new 409A valuation must be conducted. Material change events can include the following: filing a patent, settling a lawsuit, receiving new financing, receiving a term sheet for financing. After a certain amount of time they also will have to be updated. In general, in the absence of a material change event, a valuation is considered to be valid for just 12 months. A new valuation must be conducted once the 12 months are up. As well, this must be done when a new funding round is closed.
What Factors Influence Your 409A Valuation?
The IRS states that fair market values are able to be determined via a reasonable application of a reasonable valuation method. What this means is that the method must be and be done in a reasonable and consistent manner to ascertain an acceptable fair market value. Consistency is based on how other methods are performed to determine fair market value for equity. Independent appraisal will be considered 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
One of the below approaches will be used by firms that are determining the 409A to then appraise the fair market value:
A market approach is a method of determining the appraisal value of an asset based on the selling price of similar items. The market approach is a business valuation method that can be used to calculate the value of property or as part of the valuation process for a closely held business. As well, the market approach is able to help determine the value of a security, intangible asset, or a business ownership interest. Regardless of what asset is being valued, the market approach studies recent sales of similar assets, making adjustments for differences in size, quantity or quality.
This approach is prospective due to it assessing the value by using current prices of stocks and actual transactions and sales of/between companies in the same or a similar industry. The expected future benefits from the association and shared ownership between vendors and purchasers will influence how both parties go about their operations.
Learn more about 409A valuation process.
There are two areas that require attention for accurate valuation:
Are the current companies being used as guidelines for the comparison the best option, or are there other companies that would match and serve the current purpose better?
Are the correct multiples being taken from the stock market and being applied to the parameters of the company in question?
This real estate appraisal method uses the net operating income (NOI) of collected rent and divides it by the capitalization rate to get the propertyís value. In order to determine the NOI an investor will take comparable properties and look at their market sales.
After a capitalization rate has been determined, the propertyís characteristics must then be taken into account and be used to adjust the rate. One example would be if the tenants are of a higher quality than those around it then the rate would go down. Then again, if the property is less appealing than the others then it would increase the 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 contemplates a continuing business operation with potential for maintaining the current cash flow from operations that will provide a reasonable return on investment. The method can capitalize or discount the assumed maintainable post-tax cash flow in the future based on the 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.
There are two variables that determine the value under this method, A) future cash flows and B) the risk of earning those future cash flows. The better you manage these variables, the most likely youíll receive a favorable 409A.
An asset-based approach is a type of business valuation that focuses on a company’s net asset value (NAV), or the fair-market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business. 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 be interested in purchasing the property due to the large amount of easily liquidized physical assets, negating most of the fears with regards to a bankruptcy risk, or because the property has a higher availability to security when it comes to financing the acquisition.
What do I need to do to get a 409A Valuation?
You have three means of receiving your 409A valuation report:
Work with a firm: Most people end up using this method as itís a safe one. It places the burden of proof onto the IRS to determine the value of your 409A. The IRS must back it, regardless of the outcome. Itís the most expensive option, but with the right knowledge and a reputable firm backing you, it will pay off.
Use Software: This is a pretty risky choice. 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.
Personally do it: The riskiest option is to file the 409A valuation yourself. With this, there is no safe harbor protection from the IRS if mistakes have been made. 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. The best option you have is to leave the work to a professional, or be extremely well versed in 409A valuations.
Some of the most common mistakes made during a 409A valuation:
Hiring inexperienced appraisers. A cheaper firm does not equal a good service. Be sure that you only hire reputable firms.
Failing to get input from your companyís accountants before choosing an appraiser. IRS audits will require informed accountants, so donít leave them out of the loop.
Pushing your 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. Remain on good terms.
How long does a 409A Valuation Take?
Considering the many factors involved itís difficult to pinpoint a return time for the 409A valuation. The following timeline should give you a rough estimate though:
Provide your data (1-3 days): This will include your cap table, articles of incorporation, financial projections, term sheets, and past 409A reports.
Running the report (10-20 days): If you want your valuation quicker, expect to pay at least $1,000 to $3,000.
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. Keep in mind that if the IRS must become involved, or if there are mistakes made, then this process can be elongated. You can minimize your errors and, thusly, pick up the pace of the process by hiring a firm. Accuracy is key when it comes to the time frame.
What if I donít have a 409A Valuation?
Essentially no valuation means you get to live through a horrible nightmare. Without pricing your stock options the IRS will assume that you are simply giving your assets away for free. 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.