409A Compliance – Importance of Getting Your 409A Valuation In Order
The purpose of this article is to provide an overview of the 409A valuation, its significance, as well as a checklist of things to look out for when preparing for a 409A valuation.
The 409A valuation is a financial metric that private companies use to determine the fair market value of the stock. Basically, the Internal Revenue Code 409A says that the fair market value of a private company’s stock must be determined in order to comply with the rules and regulations, establish various stock-based compensations, and educate potential investors about the company. Consequently, the government requires the company to prepare a fair market value of its stock and submit it to the IRS. The purpose of this article is to provide an overview of the 409A valuation, its significance, as well as a checklist of things to look out for when preparing for a 409A valuation.
Under Section 409A of the Internal Revenue Code, a private company is obligated to obtain fair market value for its stock and report it to the IRS. Whether it is for setting up a stock-based compensation program or reporting to potential investors, the company’s stock must be evaluated. The 409A valuation, therefore, plays an important role in all aspects of a private company. As such, 409A compliance must be considered throughout the process of 409A valuation in order to avoid significant penalties. Particularly, if companies that fail to maintain compliance with the 409A valuation requirement may be held liable for negligence.
Understand deferred compensation
To brief, deferred compensation refers to pay or compensation that is not being paid out immediately because it is promised to be paid out at a later time. Usually, it includes pensions, retirement plans, and stock compensation. The distribution is held back by the employer and is released to the employee at a later date. Typically, the fraction of the compensation is collected every month for the employee, which accumulates over time; thereby, the final amount is paid as per the date previously agreed upon.
409A for qualified and non-qualified deferred compensation
Before getting into a detailed analysis of the 409A valuation process, it is important to understand the concept of 409A for qualified and non-qualified deferred compensation plans. With respect to qualified deferred compensation, the Employee Retirement Income Security Act (ERISA) defines what constitutes deferred compensation; it is defined that employees have the right to full disclosure of information about their retirement plans free of cost.
Generally, qualified deferred compensation is related to retirement plans. Additionally, creditors or employees cannot claim the funds in the case where the company fails to pay its debts. While non-qualified deferred compensation allows employees to add their money into a trust fund that’s separate from your business’ assets.
Now under Section 409A of the IRC, nonqualified deferred compensation plans are regulated by The Internal Revenue Code. Therefore, as per section 409A, companies are required to present the non-qualified deferred compensation in the manner required by the company’s governing documents.
Why is a 409A valuation necessary for private companies?
Simply put, a 409A valuation plays a crucial role in a private company because it allows a company to determine the fair market value of its stock. Unlike public companies, where the stock price is determined by the market forces, private companies need to set up a fair market value of their stock in order to comply with the rules and regulations of the government.
As such, a company needs to know how much the shares are worth in order to set up various stock-based compensations and provide information to potential investors. In addition to this, in the case where the company is going for an initial public offering (IPO) process, the 409A valuation makes up a significant part of the IPO valuation process.
Consequently, as a part of a pitch deck or press release, the company’s 409A valuation should be presented to investors in order to properly inform them of the company’s fair market value of its stock. However, be sure to follow the 409A compliance to avoid potential pitfalls and penalties.
Different types of equity grants and 409A valuation compliances
The Internal Revenue Code 409A defines what the company needs to do with respect to stock-based compensation. Before we get into the specific rules and regulations that govern these types of grants, it is important to understand the concept of equity compensation or grants. Typically, equity grants refer to a form of incentive wherein an employee receives some shares of the company in exchange for services rendered. Under the Internal Revenue Code, there are different types of equity grants that are regulated by the government. While the 409A compliances will be the same for each type of equity grant.
Why do 409A tax regulations and compliances matter?
Basically, a fair and accurate 409A valuation is required to ensure that the company is following the rules and regulations. For those who fail to comply with the 409A valuation requirement, the IRS could impose heavy penalties. Employees, executives, or even board of directors members can be imposed a 20% penalty. Properly performing a 409A valuation could protect employees and employers from facing heavy tax penalties at a later date. That being said, follow the regulations and 409A compliance in order to avoid penalties.
Types of common stock issuance need to comply with 409A
Now that you have a general understanding of 409A and its application, it is important to learn about the various types of stocks that are issued by a company. Here are a few types of common stock issuance that are regulated under the 409A.
- Preferred Stock – It is a commonly used type of equity grant wherein the company issues shares with a preference over the common stock. Shareholders are paid with a specified dividend that has priority over common stock for receiving dividends. 409A valuation is a must to determine the fair market value of a preferred stock.
- Options – It is a type of equity compensation that gives an employee the right to buy or sell the underlying security for a specified price within a given time period. In this regard, the strike price refers to the price at which an employee can buy or sell the shares. Therefore, a 409A valuation is critical to understanding the fair market value of a stock option due to the fact that the strike price is derived from the current market value of the stock.
- Warrants – It is another type of equity compensation that gives an employee the right but not the obligation to buy or sell a security at a particular price within a duration. Usually, the underlying security is the equity of the company. Similarly, a 409A valuation is required in order to determine the fair market value of a warrant as the exercise price is determined by current market values.
- RSUs and RSAs – Restricted stock units and Restricted Stock Awards are defined as a type of stock that is granted to employees based on their performance and contributions. RSUs refers to a form of common stock which are delivered at a future date; as such they are held for a specified period of time. In general, after a certain milestone or performance goal is met, RSUs become vested, and the holders will receive a specified number of shares. Similarly, RSAs are issued to early employees who are considered contributors to the company. RSAs provide employees with the right to purchase shares at a discounted price. For both RSUs and RSAs, the Internal Revenue Code Section 409A requires a fair market value to be calculated for the stock to be granted. Thus, performing a 409A valuation is necessary in order to correctly account for any potential tax consequences.
- Phantom Stock – Another type of equity compensation is known as phantom stock. Phantom stock refers to an equity grant where selected employees, mostly senior management, receive the benefits of stock ownership without actually giving them any company stock. Hence, a 409A valuation is required to ensure that the employees are properly compensated.
What to consider for 409A compliance while issuing common stock
The Internal Revenue Code 409A defines the specific requirements for companies when issuing common stock. Basically, the stock of private companies is not traded in an open market, and it is not possible to determine the actual fair market value. Consequently, 409A compliance requires a few assumptions, projections and calculations to determine the fair market value of the stock.
409A IRS regulations and compliances
The Internal Revenue Code 409A works in a systematic manner to determine the fair market value of a specific type of equity grant. Basically, this is to make sure that the company is properly issuing equity grants by following the rules and regulations of the government. Following are a few of the general rules and regulations that are incorporated in 409A.
- The right to a benefit that is excluded from income shall not be treated as a deferral of compensation for purposes of section 409A.
- When the stock option is extended, the modification as per the 409A shall be considered if the period is not extended further than the earlier of the maximum term of the option or 10 years from the original date.
- There is a legally binding right to receive a non-taxable benefit which does not provide for a deferral of compensation under the purposes of section 409A.
How is a 409A valuation affected by Convertible Notes/Promissory Notes?
Now that you have a general understanding of the application and regulation of 409A, let’s learn how 409A compliance affects Convertible Notes or Promissory Notes. IRC 409A values get affected by convertible notes when a valuation firm does the valuation of a company. Further, then it has a convertible note in the capital structure, and they evaluate and term it as equity rather than debt, assuming that the note will be converted rather than repaid. As a result, there is a potential problem with how to value it under 409A.
409A errors and penalties
There are several errors and potential penalties that a company may face if they are not in compliance with the 409A requirements.
What are some common errors companies make in the 409A valuation?
409A valuation is based on certain projections, assumptions and estimations, and calculations, so there is a high probability for errors to occur. More realistic and accurate assumptions are essential to the process of proper 409A compliance. Be sure that your projections and assumptions are reasonable along with the required information to calculate the fair market value of your company. Here are some of the common errors that companies make when doing a 409A valuation:
- Making incorrect calculations of plan deferrals and distributions
- Not complying with Section 409A definitions of specified terms
- Not making timely payments (i.e. making late payments or early payments rather than paying according to schedule)
- Not making deferral or distribution elections on time
Penalties for making 409A valuation errors
There is a possibility of penalties for violating the 409A regulations. The IRS could impose penalties on the employees, company, executives, or board of directors members with a 20% penalty. Therefore, 409A compliance is highly advised.
How can companies avoid making these errors?
To avoid making common mistakes in 409A valuation, it is necessary to learn about 409A regulations and guidelines. Also, it is important to follow a well-researched and documented management plan that is supported by the board of directors and shareholders. Lastly, it is important to have a qualified accounting firm conduct your 409A compliance as they can help with accounting and tax matters.
How can experts’ team of valuation help with 409A valuation compliances?
By taking the right steps, experts in tax and legal consulting may be able to provide full service and help with 409A valuation compliances. Professionals and advisors provide support and assistance in the initial stage, such as filing, reporting, and responding to IRS audit filings. Thus, it is recommended to hire the services of professionals who can assist with 409A penalties and compliances.
Here are some frequently asked questions on 409A valuations and why they are important:
What are the requirements for a 409A valuation?
Generally, a 409A valuation involves a series of information including general company information, three comparable public companies, recent and planned financial rounds, secondary transactions, and convertible securities.
Which compensation is subject to 409A?
Deferred compensation is the one which is subject to 409A, but the tax treatment is different.
Is there any exception for the 409A arrangement?
Tax-qualified employer plans, sick leave or holidays, disability plans, death benefit plans, and certain medical expenses are a few 409A exemptions.
How does 409A affect the timing of election to deferred compensation?
Under regulations, such elections must be conducted irrevocably before the year in which the services are performed.
Considerations to lower your 409A valuation
Well, no alterations can be made to the 409A valuation. A fair and accurate 409A valuation must be conducted with the utmost expertise.
Why choose Eqvista to maintain your 409a valuation compliances?
409A compliance is highly recommended for any entity. It is integral and necessary to accumulate the correct information about the company and its equity plan to determine the fair market value as per 409A. Eqvista is here to help companies with their compliance needs and support your 409A valuation. Eqvista’s platform serves as the ideal solution to help serve 409A compliance. Contact Eqvista today to learn more.