409a valuation for LLC – A Complete Guide
In this article, we will explain how LLCs work and how a 409A valuation is needed for these companies.
New business owners who form a limited liability company (LLC) usually want to limit the personal liability of themselves, their partners and their investors. However, regardless of its form, every company is subject to Section 409A of the United States Internal Revenue Code. A limited liability company cannot issue shares of stock because of its structure: while the profits can be distributed among its members, these members are not shareholders of the company. So how are these companies subject to 409A valuations if shares are not issued?
409a valuation and LLC
As mentioned earlier, every company in any form is subject to Section 409A of the IRC. While a limited liability company does not issue stocks, there are alternatives that the company can issue (i.e. bonds, options, etc.). In this case, getting a 409A valuation is important in getting the strike price of options to be at fair market value.
Understand 409a valuation
A 409A valuation determines the fair market value of a company’s common shares. This assessment will allow you to pay employees fair market value for equity-based remuneration such as stock options, restricted shares, and other share-based equity instruments. Section 409A of the United States Internal Revenue Law (the “tax code”) is the source of this valuation’s name, and mandates that options issued as remuneration to service providers (employees or non-employees) have an exercise price equal to or more than the fair market value of the shares underlying the options on the date the options are granted.
Importance of 409a valuation
Getting a 409A valuation is crucial for determining an acceptable fair market value of your company’s shares. In the case of LLCs, options that are issued should be granted with a strike price equal to FMV. This is done to protect employees from tax issues and to protect you and your company from lawsuits or tax liabilities.
Overview on LLC
In a limited liability company, owners are called ‘members’. According to the IRS, members can include individuals, corporations, other LLCs and foreign entities. This is because for LLCs, ownership is not restricted. LLCs can have as many members they want, or can have it as a ‘single-member’ LLC (having only one owner).
What is an LLC?
A Limited Liability Company (LLC) is a form of private limited company that’s specific to the US. In an LLC, owners are protected from personal responsibility for its debts or liabilities. It is a business structure that includes characteristics of a corporation and a partnership or sole proprietorship.
Why 409a valuation is important for LLC
Unlike public corporations, whose worth is determined by the market, private companies have their value determined by independent appraisers. An independent assessment of the fair market value (FMV) of a private company’s common stock that determines the “strike price” for equity is an IRS Section 409A valuation. A 409A valuation is required if your organization intends to provide options. Annual and following financing events, 409A valuations are strongly suggested for:
- A business that issues stock options, restricted shares, etc (Any type of equity grants). The majority of these businesses are C corporations.
- Equity owners who plan to transfer or donate a portion of the company for reasons such as estate planning, charity trusts, donor-advised funds, divorce, and so on.
Safe Harbor 409A Valuation
When you achieve a ‘safe harbor’ status on a 409A valuation, this means that the IRS must accept the valuation to be valid unless it is seen as ‘grossly unreasonable’ by the IRS.
How to Achieve Safe Harbor Status
For determining the FMV of private company common shares, the IRS provides three safe harbor methods:
- Independent Appraisal Presumption – A certified independent appraiser determines the value as of a date no more than 12 months prior to the award date. Because of the present accessibility to receive an independent value assessment at a cheap cost from numerous appraisal companies and the credibility provided by an independent expert’s study and conclusion, this is the most popular of the three safe harbor techniques.
- Binding Formula Presumption – The formula-based applies to 409A valuations based on the company’s stock transfers consistently using one, generally applicable repurchase methodology. The legalese around this is nightmare material. Whether the transfers are compensatory or non-compensatory, this formula applies. It applies to all stock transfers made by a firm, as well as stock transfers made by at least 10% of the company’s shareholders. Formula-based valuation is the simplest technique to determine a company’s worth. It’s calculated using the seller’s discretionary income (SDE). The goal of SDE is to determine how much money a firm brings in for its owner, regardless of who that person is. The taxes you pay, your owner’s draw, and other non-essential expenses are all related to you if you own a firm.
- Illiquid Startup Presumption – The illiquid startup method which is used to protect 409A valuations, is designed to suit the startup environment, where equity changes hands considerably more frequently. It only applies if neither the service recipient nor the service provider (usually the “employer” and “employee”, respectively) expects an IPO or a change of control event within 180 days. One needs significant knowledge, experience, or training in performing similar valuations. IRS regulations define the applicable standards for this essential skill. A written report serves as proof of the valuation.
Things you should avoid when getting a 409A valuation
A simple blunder in valuation or the use of the incorrect valuation methodology can cost a corporation a fortune. It is really important to hire a 409a valuation expert in order to avoid such mistakes.
- Haggle with valuator – Because of their poor product margins, several businesses cannot afford to cope with hagglers. In such cases, there are a number of approaches that can be used to discourage haggling customers. Haggling is the process of negotiating a price until a common ground is reached. Aside from price, there are a number of other factors that can be negotiated to ensure that both the buyer and the seller are satisfied with the transaction.
- Hiring the wrong valuator – CFOs and management of startup, early-stage, and growing companies should endeavor to understand the requirements of 409A and ensure they have the right processes in place to be compliant before giving any stock options. This can assist them in avoiding or better managing risks, as well as supporting board and management fiduciary obligations linked to fairness. It’s important to hire an expert.
- Overlooking accounts – A 409A valuation can improve a company’s accounting and reporting processes, such as the need to record share-based compensation expenses, in addition to assuring compliance with tax regulations. Prior to issuing stock options, taking the time to understand the accounting and reporting implications will assist ensure GAAP compliance and limit the risk of errors or deficiencies being revealed during the audit process.
409A valuation penalties
Getting a 409A valuation can prevent you from getting penalties from the IRS. However, there are instances that some firms may not comply. Noncompliance with section 409A of the IRC can result in the following tax penalties for employees:
- Income tax and 20% penalty on any deferred vested amounts under the NQDC plan
- Premium interest tax of 1% above the federal underpayment penalty rate on failed compensation
- Additional penalties (if any) as a result of understating income
- Any other penalties imposed by the state
Get expert help for a 409a valuation for LLC with Eqvista!
While using these less-than-ideal traditional models, a valuation methodology that delivers the most accurate appraisals is feasible. We use a combination of our team of valuation specialists and software to improve accuracy and efficiency. Our analysts may spend more time evaluating assumptions, researching public firms, and reviewing transactions with the help of software, which double-checks for errors and outliers. We at Eqvista ensure that your company’s valuation is accurate and transparent. Do get your 409a valuation from us; contact us for more information.