Founders, management and employees should familiarize themselves with 409A valuations early in a company’s life. Section 409A of the Internal Revenue Code plays a crucial role when it comes to hiring and equity compensation considerations.
What is a 409A valuation?
Finalized in April 2007, Internal Revenue Code section 409A applies to discounted stock options and stock appreciation rights (SARs) defined as deferred compensation.
Under section 409A, stock options that have an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges. In short, the consequences for noncompliance, which affect the individual who holds the options and not the issuing company, are significant.
To avoid these consequences, management teams can issue options with an exercise price at FMV, and section 409A provides clear approaches on how to develop compliant policies. These safe harbors shift the burden of proof of noncompliance to the IRS. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the FMV.
What are the key inputs in determining a 409A valuation?
It depends on the stage of the company and complexity of transactions, but factors considered include financial statements (historical and projections), capital structure/rights and preference of securities, market/industry outlook, business model/outlook, public comparable companies/comparable transactions, and expectation/probability of timing for exit and failure.
At what point is a company required to do a 409A valuation?
A company must do its first 409A valuation prior to the first issuance of stock options.
How often must a company do a 409A valuation?
A company must do a 409A valuation every 12 months at a minimum, and any time a major change has occurred that either reduces risk or materially changes forecasts. Practically speaking, this means after a new round of financing is raised, or after any transaction involving the company’s assets takes place (e.g., the company has acquired another, or divested itself of material assets).
What is “fair market value”?
Fair Market Value (FMV) refers to the age-old standard of value to which the IRS adheres. Fair Market Value is defined in IRS Revenue Ruling 59-60 as:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
Revenue ruling 59-60 goes on to say that: Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
There is also Fair Value (FV), or the GAAP valuation standard, which is defined by the Financial Accounting Standards Board (FASB). For 409A purposes, the FMV is the standard of relevance; but most 409A valuation reports these days comply with both FMV and FV standards.
What are the safe harbors for 409A valuation and why do they matter?
The reason the 409A safe harbor is so important is that it shifts the burden of proof to the IRS, meaning the company’s valuation is presumed to be correct unless proven grossly unreasonable.
There are several safe harbor methods outlined in the 409A code, including: the illiquid start-up, binding formula, and independent appraisal approaches.
In order for any of the safe harbors to comply, the method must incorporate evaluation of a number of factors, including: (i) the value of tangible and intangible assets of the company, (ii) the present value of future cash flows, (iii) the public trading price or private sale price of comparable companies, (iv) control premiums and discounts for lack of marketability, (v) whether the method is used for other purposes, and (v) whether all available information is taken into account in determining value. Simply put, section 409A allows a company to find a safe harbor within the Code by obtaining an appraisal of company stock by an established firm practiced in the art of business valuation.
Can a company do its own 409A valuation? What are the requirements?
A company is allowed to do its 409A valuation in-house, although it’s usually not a good idea. The 409A regulations allow “persons with significant knowledge and experience or training in performing similar valuations” to conduct a valuation for 409A purposes and stay within the safe harbors allowed by 409A. The IRS takes care to define “significant” as having at least five years of expertise in “performing similar valuations.” Clearly, a VC or PE investor, or board member, or CFO “values” companies all the time. However, very rarely have we known any such person that actually has so much expertise performing similar valuations, for 409A valuations are very particular and nuanced in their execution. Therefore, it is important to use reputable, qualified, experienced appraisers who follow generally accepted valuation standards, approaches, methods, and procedures.
What are the pitfalls of issuing options whose exercise price is deemed to be lower than the FMV of the underlying stock?
If the exercise price is deemed lower, it can prove problematic. The IRS and others can essentially tax and penalize the employee in major ways, wiping out all the employee's winnings.
If the exercise price is higher, there should not be an issue.
How much does a 409A valuation from a third party valuation expert cost?
For a seed-stage startup with a $1 million convertible note financing, expect to pay between $3,500 and $4,500 from firms of reasonable quality and reputation, if they specialize in early stage entities. For a late-stage entity, pre-IPO valuations could cost $8,000 to $15,000 per valuation, with valuations occurring every 3 to 4 months. Just like legal and audit fees, your budget for financial valuation compliance will expand as your company does. Prepare to spend $4,000 in year one and $40,000 in year five for valuation compliance.
Any other issues management should think about relating to stock option valuations?
We have seen an increasing amount of litigation (e.g., employee vs. company) in the very recent past, leading us to believe that 409A valuations are being used for a variety of purposes beyond just IRS and SEC compliance. This is setting the stage for fights over valuation after companies succeed or fail. To avoid this dispute, or at least be better prepared when it occurs, company management is wise to procure contemporaneous valuations of high quality throughout a company’s life. This alone can make a huge difference for company management as they inevitably face these difficult situations.