409a valuation in Europe

Startups have become increasingly global in their operations in recent years. Companies from Europe consider establishing a presence and hiring staff in the United States. They also want to provide incentive compensation to crucial US employees, given the nature of new organizations. As a result, these businesses, which are often small, must adhere to European securities, tax, and employee requirements. Companies in Europe must demonstrate that stock options and other equity incentives offered to workers (and advisors) are not priced below “Fair Market Value” (FMV) when awarded, according to IRS regulation 409A.

European Companies in the US

European firms are rushing to list in the United States at the highest rate in two decades, enticed by the prospect of greater values, even as continental exchanges ramp up attempts to retain firms at home. European corporations are making significant investments and creating jobs in the United States. Thousands of jobs have been generated in the United States by ABB, Electrolux, Siemens, Holcim, Zurich Insurance, Allianz, Daimler, BMW, Volkswagen, Novarties, Nestle, and many others. As American companies relocate their manufacturing operations.

Overview of European companies and business with the US

The European Union and the United States have the world’s largest bilateral trade and investment partnership and the world’s most integrated economy. The United States is the EU’s largest import source for products, and it is also the EU’s greatest trade and investment partner. The EU and the United States are each other’s largest foreign direct investment sources. In 2019, the EU’s outbound stock totaled €2.2 trillion. External connection, and inward stock of €2.0 trillion.

Important US tax issues to know

There are certain US tax issues that a company needs to be aware of if they are doing business in the US: 83(b) election, ASC 718, ISO 100k, and Form 3921 & 3922.

• 83(b) election – Under the Internal Revenue Code (IRC) 83(b), an employee or startup founder is allowed to pay taxes on the complete FMV of restricted shares at the time of grant. This is for equities with a vesting period, and it instructs the IRS to tax the elector for stock ownership at the time of gift rather than when the stock vests.
• ASC 718 – ASC 718 is a set of accounting regulations that corporations must adhere to. According to the regulation, employee stock-based compensation is expensed on an income statement. Equity awards are a type of compensation that is subject to ASC 718.
• ISO 100k – ISO 100k is a limitation on the amount of ISOs an employee can vest per year, and the limit is $100,000. This limit is a rule from the IRS that prevents ISO programs from being abused as a tax shelter since ISOs are still subject to Alternative Minimum Tax (AMT) to prevent wealthy individuals from sheltering their income.
• Form 3921 & 3922 – Form 3921 and 3922 are two forms used for reporting ISO exercises and ASPP share purchases respectively. Every time an exercise or purchase is made, a new form must be completed and filed.

409a Valuation & Europe Companies

The IRS 409A valuation in Europe applies to international early-stage companies that have a subsidiary in Europe and want to provide stock incentives to European employees. The same rules apply when reincorporating a foreign early-stage company in Europe (i.e. an inversion of structure). While tax penalties may be imposed in the future if a 409A valuation in Europe is not completed, the more immediate issue is that the lack of a 409A valuation is likely to become an issue during the due diligence process when the firm seeks further funding or negotiates a sale or merger. Having to undertake a 409A valuation in a hurry and, at that time, concerning a date that could be many years earlier is costly in terms of expenses and, perhaps, lost negotiation leverage.

What exactly is 409a valuation/regulation?

The IRS regulation IRC 409A states that stock options cannot be issued for less than their fair market value. A 409A valuation is an impartial third-party valuation of your company’s common stock required to grant stock options to employees. The law requires a 409A valuation. To guarantee that your organization complies, you’ll need a 409A valuation. Noncompliance can lead to disastrous results, and stock option undervaluation can result in significant IRS penalties and missed compensation.

When is a 409a valuation required for a European company?

A 409a valuation in Europe is required by the company when it doesn’t know the value of the stock it is keeping. For example, If you want to sell a table but don’t know its worth, you sell it to anyone. Using the same analogy, a 409a becomes vitally important if a firm intends to offer equity. It’s impossible to sell shares if you don’t know how much they’re worth. Similarly, when we talk about European companies, 409a valuation mandates audit the valuation of stocks and their fair market value.

US Holding company with the European subsidiaries

The US Mission to the European Union and all US embassies in Europe are dedicated to assisting American businesses in starting or expanding their exports to the European Union. The global network of trade experts is based in the United States and at US embassies and consulates in nearly 80 countries across the world, including the European Union. While making your first export sale or expanding your business in the European Union, the United States can help you connect with lucrative business possibilities through trade counseling, market intelligence, business matchmaking, and commercial diplomacy.

Furthermore, many holding firms in the United States are responsible for European subsidiaries. They can assist them design trade financing and insurance strategies that correspond with your specific business goals and help you execute their export transaction.

Europe Holding company with US subsidiaries

In Europe, parent firms can try to shield themselves from liability for the actions of their foreign subsidiaries by structuring their connections in such a way that courts are less likely to find salient aspects that give rise to a duty of care. Franked dividends (dividends paid out of profits due to European tax) received by European firms are subject to a ‘gross-up and credit’ procedure. The corporate shareholder is entitled to a tax offset after grossing up the dividend received for tax paid by the sending firm (i.e. franking credits attached to the dividend.

Europe companies with US employees (Offering ESOPs/Other Incentive Programs)

Employee share plans have long been a feature of the remuneration packages offered to employees of European-listed companies. Employers can provide stock plans to all employees (all-employee plans) or senior executives and executive directors on a case-by-case basis. Companies use staff incentive schemes for various reasons, including meeting or exceeding sales objectives, increasing production goals, raising employee morale, and rewarding exceptional employee performance, all of which contribute to the company’s success. Employees are rewarded for their accomplishments, and a sense of success is created. Simple rewards, such as gifts, plaques, or trophies, to monetary prizes, such as profit sharing, bonuses, or travel incentives, are all examples of incentives.

Other situations for 409a valuation

There are other situations that a 409A valuation is needed for a company, which are as follows:

• ESOP in Europe – Employee stock ownership plans, or ESOPs in Europe, allow employees to own stock in a company, increasing employee buy-in and investment while also encouraging accountability and a sense of ownership. Stock options, stock purchases, phantom stock ownership, or a combination of these options may be used.
• Is ESOP Regulated in Europe? – Employee stock ownership in European countries is heavily influenced by the appropriate corporate and tax legislation. In general, several individuals and collective participation forms are linked to the company where the person works or to other company shares. Offering employees a share (most notably, stocks) in their company is a common (and very common) method of participation in European countries. This is frequently accompanied by unique conditions such as pre-determined holding periods and tax benefits. A holding company (for example, an ESOP or ’employee share ownership plan’ in the UK) or an individual employee account (for example, an ESOP or ’employee share ownership plan’ in the UK) administers company shares. In all circumstances, participation is a legal form of ownership, with all of the rights that come with it.
• Transfer of Shares involving US shareholders – Any Shareholder may call a Shareholders’ Meeting at any time. The Secretary must give each Shareholder at least 21 days’ notice of each Shareholders’ meeting, with the mechanism for delivering such notice following the terms of Clause 19. The Secretary shall include the meeting’s date, time, and location, as an adapter to be discussed in such notification. The Shareholders may agree in writing to a shorter notice period, in which case the conference will be regarded adequately called. All Shareholders’ meetings must be held in a site convenient to the Shareholders or the majority of their holdings unless they agree otherwise.

409a valuation issues with European companies

A valuation analyst will face certain unique problems when doing a business assessment for 409A reasons with a foreign parent company in Europe. These are some of them:

• Some clients needed to set up a trust to which the company would issue non-voting shares in order to offer options.
• On these nonvoting shares, options are then issued. Many European and Asian countries adopt IFRS, while smaller countries employ statutory reporting methods, which necessitate the adjustment of asset and revenue valuations to conform to GAAP grounds.
• In general, equity market risk will be higher than in Europe, while government bond yields may be higher or lower.
• Because a tiny share interest will be valued less than its nominal proportion of a 100%equity value due to lack of control features and marketability, it is common to apply a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM) in 409A valuations.
• However, these estimates frequently rely on European stock market empirical studies or data from European stock market transactions, with no counterpart for foreign markets.

Why is a 409a valuation important?

A 409A valuation is used to estimate the cost of purchasing one company share. This appraisal is based on the current market value (FMV). It’s a paradigm that all private enterprises should use when analyzing their stock.

• Determines the fair market value of shares – Getting a 409A valuation determines the fair market value of your company’s shares, and the FMV is needed when you are selling shares. The 409A valuation also determines the strike price for options granted to employees, advisors and anyone else who receives common stock.
• Determines the company’s financial standing – Management and investors can gauge where the company is at with regards to its financial standing. The 409A valuation can help you understand your company better and make better decisions on what to do with finances and funding.
• Safe harbor status – In order to obtain safe harbor status, you need to have a 409A valuation. This means that you protect your employees from any tax issues with the IRS. It also protects the company and owners from any lawsuits or tax liabilities.

Consequences for not complying with 409a while issuing equity

For nonqualified deferred compensation (NQDC) that contain stock appreciation rights (SARs) and stock options, it is important to have an independent company valuation to determine the strike price at which the opportunities and SARs can be exercised.

By not complying with Section 409A, you risk penalizing your company and employees.

Tax Penalties

There are several tax penalties that can happen if there’s a failure to comply with section 409A:

• An income tax and 20% penalty could be imposed on any deferred vested amounts under the NQDC plan as of the last day of the vesting year.
• Employees will be asked to pay premium interest tax of 1% above the federal underpayment rate on failed compensation from the vesting date forward.

Common Valuation Methods

While conducting valuations, analysts use three valuation methods: asset approach, market approach, and income approach. Each method has a distinct way of getting the value of a company and the best method to use depends on every company.

• Asset Approach – In asset valuation method, the value of a company is based on its assets. It is obtained by subtracting the total liabilities from the total assets, which results in the net asset value. Tangible assets can include real estate and cars, while intangible assets include intellectual property.
• Market Approach – The market approach assigns a value to a company based on market forces in comparable situations. This method relies heavily on existing data in order to compare other companies in the industry. Under the market approach, there are two methods on how businesses are compared: public company comparables method and precedent transactions method.
• Income Approach – In the income approach, the company is valued at the present value of its future earnings or cash flows. This method does not use any past similar transactions in order to obtain the value of the company. The two main methods in the income approach are: capitalization of earning method, and discounted cash flow method.

Example of a 409A valuation in Europe

Automazione Manufacturing, which manufactures and exports sporting goods around the world, has senior managers and executives who are expats and US citizens. These senior staff need to declare tax back in the US for their stock options they plan to exercise in the future. To determine the strike price on these options, Automazione Manufacturing has a 409A valuation done to find the value and exercise price for their ESOPs.

This is how their basic cap table looks like:

After getting the 409A valuation process, the resulting value was calculated as:

With the total valuation of the company at $9,870,00 after the DLOM, and capital structure with 23,060,000 shares, after processing the value through a waterfall analysis, the final share price was calculated as:

$0.30 price per share

After the valuation, Automazione Manufacturing was able to issue its stock options according to its ESOP plan at a strike price of $0.30 to its US staff.

Get a certified 409a Valuation Report for Your Company.

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If you are unsure where you can get your 409a valuation, we are here to help you. Book a free consultation today, and we will explain the entire valuation process.