409A Valuation in India

In this article, we explain what a 409A valuation is, and in which scenarios do you need a 409A valuation in India.

India is the hub of the startup industry and is the main market for multinational companies. We have seen a sudden growth in foreign direct investment and increasing employment opportunities in India in the past few years. With this, startup companies have to provide the initial compensation to the foreign companies and must comply with their securities, tax, and employee regulation.

One such compliance is a 409A valuation. It is important to know whether your company needs a 409A valuation in India. In this article, we explain what a 409A valuation is, and in which scenarios do you need a 409A valuation in India.

Indian Companies in the US

India’s second-largest source of foreign direct investment (FDI), second-largest trading partner after the EU, and most significant services export destination is the United States. There is a lot of potential for India and the U.S. to strengthen their relationship further and increase their economic ties by effectively leveraging India’s inherent advantages. In a report conducted by the Confederation of Indian Industry(CII) in 2020, it highlighted a wide variety of Indian companies doing business all over the U.S. The report gave new insights on how the U.S. is the leading investment destination for Indian companies.

Overview of Indian companies and business with the U.S.

India presents itself with a growing economic potential for U.S. investors. Manufacturing, agriculture, and retail are all growing industries in India, and many of the top IT companies are based in the country. U.S. companies Walmart, Amazon, and Skechers have announced major development ambitions in India recently. India’s new economic initiatives and tax reforms aim to attract more significant investment, and the country is well on its way to becoming a digital economy. However, there are still obstacles to overcome, and a thorough understanding of local legal, financial, employment, and taxation regulations is required.

Important US tax issues to know

  • 83(b) election – The Internal Revenue Code’s (IRC) 83(b) election allows an employee or startup founder to pay taxes on the complete fair market value of restricted shares at the time of grant. The 83(b) election is for equities that have a vesting period. The 83(b) election instructs the IRS to tax the elector for stock ownership at the time of gift rather than when the stock vests.
  • ASC 718 – Employee stock-based compensation is expensed on an income statement in accordance with ASC 718. Equity awards are a type of compensation that is subject to a set of accounting regulations known as ASC 718 that corporations must adhere to. Expense accounting was previously known as FAS 123(r), but it is now governed by ASC 718.
  • ISO 100k – In contrast to Non-qualified Stock Options (NSOs or NQSOs), Incentive Stock Options (ISOs) receive preferential IRS treatment. The key advantage is that when the option is exercised, the spread between the fair market value (FMV) and the initial exercise strike price is not subject to ordinary income tax. Ordinary income tax is withheld on the spread by NSOs at the time of exercise. ISOs, on the other hand, are nevertheless subject to the Alternative Minimum Tax (AMT) in order to prevent affluent persons from hiding all of their income in this method. Another IRS rule designed to prevent the ISO program from being utilized as a tax shelter is the $100K Limit (100K ISO Limit).
  • Form 3921 & 3922 – The IRS has issued two forms (and instructions) for reporting ISO workouts and ESPP share purchases: Form 3921 for ISO exercises and Form 3922 for ESPP share purchases. For each workout or purchase made during the calendar year, a new form must be completed and filed. As an example, if an employee used many ISO awards over the course of a year, in a calendar year, the employee must receive a copy of Form 3921 for each exercise, and the corporation must receive a copy of Form 3921 for each exercise, will be required to file numerous tax returns with the IRS.
  • Internal Revenue Code Section 409A – A 409A is an impartial evaluation of a private company’s common stock, or equity reserved for founders and workers, at fair market value (FMV). It is used to calculate the fair market value (FMV) of your company’s common stock which a third-party valuation firm usually does. The cost of purchasing a share is determined by this valuation.

409a Valuation

A 409a valuation is an assessment of a private company’s stock and determines the fair market value (FMV) of that company. Unlike public firms, private companies have no share prices available to examine at any time. Private companies that want to issue shares to their employees must have them assessed. This is where the 409A valuation comes in.

409A valuations should be done annually or if the company has a material event, such as new financing, to take advantage of the IRS safe harbor (i.e., not be subject to certain IRS fines).

What is IRS 409a regulation?

Internal Revenue Code section 409a of the United States regulates the specific design or operational restrictions. If this section is breached, a 20-percent excise tax is imposed on non-qualified deferred compensation provided by a “service recipient” to a “service provider”. Employers are the most common service recipients, although those who hire independent contractors are also service recipients. Executives, general workers, some independent contractors, board members, and companies that provide services are examples of service providers (an LLC, for example, could be a service provider).

In general, Section 409A mandates that “non-qualified deferred compensation” adhere to a set of criteria governing the timing of deferrals and payouts. Section 409A applies anytime there is a “deferral of remuneration”, which occurs when an employee has a legally binding claim to compensation that is or may be payable in a later taxable year within a taxable year, according to IRS regulations. There are a number of exclusions that exempt payments that would otherwise fall under this description from the Section 409A regulations, including Qualifying plans such as pensions and 401(k)s and welfare benefits such as vacation, sick leave, disability pay, and death benefits.

409a Valuation & Indian Companies

Most business owners do not know the importance of a 409A valuation and whether they should get one for their company. For companies in India, it’s important to learn whether your company is required to get a 409A valuation, and where you can get your valuation done.

When is a 409a valuation required for an Indian company?

A 409a valuation 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 how much it’s 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. A 409a valuation is required if your company is:

When is a 409a valuation required for an Indian company?

A US Holding company with Indian subsidiaries

The U.S. has a lot of Indian subsidiaries, giving them an edge to earn revenue and build strong economic relations. Since material resources are cheap in India, the U.S. imports their resources from India. Therefore, there are a lot of Indian Subsidized Industries in the U.S. Many investors and commercial firms want to establish a company in the U.S. in order to grow their product and service horizons in other developed regions such as the U.S., Europe, and South America. Setting up a business in the United States has various advantages, including increased credibility in the international market, the ability to recruit angel investors, and tax benefits, among others.

In the United States, any Indian or foreign national can form a C-Corporation (Company) or an LLC (akin to an LLP). An ‘S-Corporation,’ however, is a different entity that requires all stockholders to be US citizens. A U.S. corporation or LLC can have as many owners as it wants, regardless of which nation they are from.

US Holding company with Indian subsidiaries

An Indian company with employees who are U.S. citizens (Offering ESOPs/Other Incentive Programs)

Employee stock ownership plans (ESOPs) have shown to be a successful retention tool around the world. A variety of global enterprises with an existing Indian presence and investors looking to establish a greenfield presence or purchase operational businesses in India should consider cross-border ESOP models. Indian corporations can also issue ESOPs to employees of their international holding, subsidiary, or joint venture enterprises. This article examines several cross-border ESOP models and highlights essential issues raised by Indian corporate, foreign exchange, and tax legislation.

Indian company with employees who are U.S. citizens

Foreign firms’ incentive programs for Indian staff

Foreign companies may issue stock options under their ESOP schemes to employees or directors of their Indian offices (“Foreign Options”), provided that the Foreign Options are offered globally on a uniform basis; (ii) the Indian office files an annual return with details of Foreign Option exercise by Indian employees; and (iii) amounts payable on the sale of any shares held according to Foreign Option exercise by Indian employees are disclosed. The foreign business may also choose to repurchase the granted or vested Foreign Options and any shares issued according to the Foreign Option Agreement.

Indian corporations’ incentive strategies for international staff

An Indian firm can offer ESOPs (“Indian Options”) or sweat equity shares to employees/directors of its holding company, joint ventures, or subsidiaries outside India under the provisions of the Indian foreign direct investment guidelines (“FDI Policy”). Indian companies must: grant Indian Options under their ESOP scheme, which must comply with the Indian Companies Act, 2013 (“Companies Act”), as well as the applicable limits and conditions for the foreign direct investment amount under the FDI Policy; and (ii) file a return with the central bank within 30 days of the issuance of the Indian Options.

Indian corporations' incentive strategies for international staff

Other situations for 409a valuation

Suppose the stock was valued within 12 months of the pertinent option grant date and no material change occurred between the valuation date and the grant date. In that case, the 409A valuation is assumed to be reasonable. If these conditions are met, the IRS must show that the valuation is “grossly unjustified”. A change in management of the business, the occurrence of an unanticipated emergency, or the employee’s disability, death, or separation from the firm are all Section 409A triggering payment events when the nonqualified deferred compensation plans time limit expires.

Indian Tax Law for valuation

A lot has been said about how Angel tax is affecting the growth and sustainability of startups in India, and the government has partially acknowledged it recently. However, the implementation of specific provisions of income tax law in India by income tax officers, as well as the judgment over the basis of valuation of the company, has created a lot of noise and uncertainty for businesses and investors. While much of the focus is on startups, the Income-Tax Officer’s decision on the basis of valuation is affecting a lot of other companies that are raising capital. It is a well-established principle that taxes on income by capital are being abused by applying anti-abuse provisions, which is more concerning. The government is also aware that it is in the process of establishing valuation standards in India. The ministry of corporate affairs has already established a committee to advise on valuation by making recommendations, as well as the formulation and implementation of valuation standards and policies for companies and registered valuers to follow.

Reasons for using ESOPs

Companies can employ ESOPs to keep all members focused on the company’s success and share price appreciation because ESOPs are part of the company’s remuneration plan. Employees at all levels of the company are involved, even at the stock level, and the participants do what is best for the company’s shareholders since they are now shareholders. To summarise, an employee stock ownership plan provides a sense of ownership in the company, which enhances an employee’s confidence and motivates him to perform more for the company.

Cost and Tax implications

Employee stock ownership plans are often supplied free of charge to employees. Until the employee resigns or retires, the company may place the stocks in a trust for the employee’s safety and growth. The corporations tie dividends from planning to vesting (the proportion of shares earned for each year of service).

Taxation is commonly levied on employee stock ownership plans. When an employee exercises his option, the difference between the exercise price and the Fair Market Value (FMV) on the day of exercise is taxed as a perquisite. An employee stock ownership plan is considered a bonus in terms of taxation.

Why is a 409a valuation important?

Why is a 409a valuation important?

Defining the fair market value of shares

A company’s post-money valuation, which is based on how much investors paid for their own position after fundraising, is often (but not always) different from its 409A valuation. Because preferred stock is given to investors, a post-money valuation is based on preferred stock price, but a 409A is based on the common stock price. Preferred stock is frequently more valuable than regular stock due to particular characteristics.

The fair value of the company

A 409A is used to calculate the fair market value (FMV) of your company’s common stock, which a third-party valuation firm usually does. The strike price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As.

Safe harbour status

While companies frequently conduct their financial analysis to estimate FMV early in its lifespan, valuations grow more complicated as time goes on, requiring more knowledge and taking longer. Eqvista helps you in filing a 409a valuation and offers safe harbor status.

Consequences for not complying with 409a while issuing equity

An independent company valuation is necessary for nonqualified deferred compensation (NQDC) plans that contain stock options and/or stock appreciation rights (SARs). The valuation determines the striking price at which the opportunities and SARs can be exercised.

The penalties of not complying with 409a can be severe for the company and the employees too. The sanctions will ruin your staff before they ruin your firm, but you can bet the two will happen in quick succession.

Tax penalties

Noncompliance with section 409A can result in the following tax penalties for employees:

Even if payment is made in the following years, employees must pay income tax and a 20% penalty on any deferred vested amounts under the NQDC plan as of the last day of the vesting year.

Employees must pay a premium interest tax of 1% above the federal underpayment penalty rate on failed compensation from the vesting date forward. They may be required to pay additional penalties as a result of understating their income. They may also be subject to penalties imposed by the state.

Common Valuation Methods

The common valuation methods are those that their companies use to calculate and check the stored stock. There are three differences that have been used to analyze the value of the stock along following the instructions mentioned in the 409a section.

  • Asset approach – A company’s net asset value is the emphasis of an asset-based approach to business valuation. Total liabilities are subtracted from total assets to arrive at the net asset value. There is some space for interpretation when determining which of the company’s assets and liabilities to include in the assessment and how to measure their worth. Financial executives have a significant duty in determining and keeping awareness of a company’s value. When a company’s value rises, stakeholder and investor returns rise as well, and vice versa. There are several methods for determining a company’s worth. The equity value and enterprise value are two of the most common. The asset-based approach can be utilized with these two methodologies or as a stand-alone appraisal. The use of the equity in the computation is required for both equity value and enterprise value. Analysts may utilize asset-based valuation as an alternative if a company does not have any stock.
  • Market approach – The market approach is a method for calculating an asset’s worth based on the selling price of similar assets. Along with the cost technique and discounted cash-flow analysis, it is one of three main valuation methodologies. In circumstances where there is a lot of data on similar transactions, the market method shines. Alternative procedures may be required if that data is not available.
  • Income approach – The income technique estimates fair value based on the income generated by the property. The capitalization rate is divided by the net operating income to arrive at this figure. When it comes to business valuation, the income method reigns supreme. The majority of people start a business to make money. As a result, if someone is buying a firm, the amount of money they will generate in the future is the most important consideration in determining the purchase price. In simple terms, the income strategy is analyzing a company’s financial history in order to forecast future earnings.

Calculations for 409A Valuation in India

Let’s say there is a company, International Steel Exports Pvt. Ltd, which exports steel all over the world. This company has some senior managers and executives who are expats and US citizens, who need to declare tax back in the US for their stock options they plan to exercise in the future. In order to determine the strike price on these options, International Steel Exports Pvt. Ltd decides to undergo a 409a valuation to find the value, and exercise price, for their ESOPs.

Here is a basic look at their Cap table:

Security NameSharesFD%
Common Stock12,000,00035.82%
Preferred Stock18,000,00053.73%

After having their 409a valuation processed, the resulting value was calculated as:

Calculations for 409A Valuation in India

With the total valuation of the company at $9,100,000 after the DLOM, and capital structure with 33,500,000 shares, after processing the value through a waterfall analysis, the final share price was calculated as:

$0.19 price per share

With this, International Steel Exports Pvt. Ltd was able to issue its stock options according to its ESOP plan at a strike price of $0.19 to its US staff.

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