5 things you need to know about 409a valuation
Before a company gives out employees stock options, a company valuation according to IRC 409a (409a valuation) should be conducted.
Organizations offer stock options to their employees as a form of motivation. With a stock option, the holder is allowed to buy a specified number of shares of the company at a predetermined price (strike price). This helps motivate employees to work hard for the company, and when the company value increases, so too does the profit from their employee compensation.
This article covers the 5 most important things to know about 409a valuations.
What is section 409a?
Introduced in 2005, Section 409a of the Internal Revenue Code (“IRC”) is a complicated framework. It states that stock option awards are to be issued at strike prices at or over fair market value for private companies. Section 409a places deferred compensation into five different categories: foreign plans, stock options, section 457 plans, and qualified employer plans. Timing restrictions are also defined and the penalties for breaking rules, for example, when unqualified and qualified plans are payable, and others.
The aspects of a business subject to valuation according to its relevance is also outlined in IRC 409a, which includes control premiums, cash flow, marketability, and its assets. The key to avoiding consequences financially is to properly understand and consider all elements of these regulations. This creates the need of assistance from a valuation professional.
To lay the groundwork to incentivize your employees and attract new hires through deferred compensation, you will need to comply with IRC 409A. For startups to head in the right direction, they also need to comply both in terms of state and federal law, wherever applicable.
For example, in a situation where you offered your contractors and employees to buy 10,000 shares at $1 per share, you would need a 409a valuation to justify this share price. If not done, in the future the IRS may review your company value, and determine the share price on that day should have been $2 per share. A penalty of 20% will be imposed on your employee and they will also be required to pay the difference in the amount. In this scenario, the employee will have more than $2,000 in fines, plus the difference in share prices. To avoid these penalties, it is vital to get a 409A valuation done with the right method and get safe harbor protection.
Safe harbor protection means that the company will effectively be shielded from IRS audits, unless they are able to prove that your valuation is “grossly unreasonable”, otherwise the IRS must accept the valuation. A company may be exposed to the full employee contributions of qualified retirement plans, tax penalties, and additional taxation if they fail an IRS audit and do not have a safe harbor status. We will cover this more in the next sections.
When does my company need a 409a Valuation?
If your company offers common stock options, there are three times that you have to perform a 409A valuation:
- Before the company issues their first employee stock options
- Annually (The share price from 409a valuations are valid for 12 months)
- Whenever you close a new funding round.
For better understanding, a 409A valuation will be required immediately when you first issue employee stock options. From that point onwards, you need to get the valuation done annually. Take note and be sure that you are on top of redoing the valuation every year as they are only valid for 12 months. Also, if your company goes through any major changes in its business, you would need a 409A valuation depending on what type of change the company has gone through.
What is 409a Valuation Safe Harbor?
You already know what a 409A valuation is, so you would also know that safe harbor protection for 409A is the most important thing. But just how important? Here we will tell you the details about it, why it exists, and what happens if you are in non-compliance.
409A penalties are high for non-compliance, such as a potentially greater tax bill, hefty fines, and irreversible reputation damage. But it exists for a reason. Another Enron scandal can be formed through another inaccurate 409A valuation, and no one wants that. Inaccuracies can be significant, which is why the IRS does not want companies fostering 409A valuations on their own.
Startups are provided with different opportunities by the IRS for their company valuation by which they can get safe harbor. Below are three conditions to consider for “safe harbor” status. They are:
- Independent Appraisal Safe Harbor
- Binding Formula Safe Harbor
- Illiquid Startup Safe Harbor
Individually each opportunity is unique and complex as they present you with a clear and straight path to attain a safe harbor 409A valuation. Let’s look at them in detail:
Independent Appraisal Safe Harbor
The independent appraisal opportunity is the easiest and most common to pursue when it comes to 409A safe harbor valuation methods. An independent firm that exercises well-documented and consistent methodologies in their 409A valuation appraisals are what the IRS wants. Typically this is the easiest way to get to safe harbor.
Binding Formula Safe Harbor
The constant use of one commonly-applicable repurchase formula in the company’s stock transfer is when the binding formula safe harbor applies for 409A valuations. No matter if the transfers are compensatory or non-compensatory, this formula is applied. It is imposed on at least 10% of the company’s shareholders’ stock transfers and on all of the company’s transfers.
The IRS specifies that any person who holds more than 10% of the merged voting power across every class of the issuer’s stock is void from this exemption. This leads to making this provision unattainable for the majority of companies (any company in which a shareholder holds more than 10% of the shares).
The “arm’s length transactions” is the presumption that is an exemption to the binding formula safe harbor related to the company’s stock. These are events where the buyer and seller both have no previous association and act autonomously of each other’s interests. For the company’s shares, the formula only applies when it is utilized as a part of non-lapsing restrictions. In principle, you do not fall under this category to achieve an exemption unless your company has a valuation of $100m+ and more than 100 individual shareholders.
Illiquid Startup Safe Harbor
For a 409A valuation safe harbor, according to the illiquid startup opportunity, is devised to support the startup environment where equity shares switch from hand to hand frequently. When an IPO is not anticipated within 180 days or change of control does not happen within 90 days between both the service provider and the service recipient (employer and employee), then this can be applied. A ‘Change of Control Event” can be a transfer in voting power, to the point that more than 50% is held by one entity or person. You will know when you see this transfer.
Your 409A valuation should be done by a qualified individual according to the illiquid startup presumption. Someone who companies can fairly rely on based on the combination of education, experience, training, and knowledge. Also, they need five years of relevant experience.
Failing to Achieve a 409A Valuation Safe Harbor
As a compulsory part of running the company, you should be aware of the 409A valuation safe harbor requirements. The penalties for failing to achieve a reasonable valuation as determined by the IRS would result in penalties on every employee deferring compensation. For the present and all past years for which the compensation was deferred, they will be fined a tax. Additionally, the rest of the balance of the deferred compensation will also be imposed on them with another 20% excise tax.
On top of all these charges, the IRS charges a premium interest rate, which is 1% on top of the federal underpayment rate. The employees would be hit with fines, penalties, and fees one after the other as they struggle to pay off the owed amount. So if you fail to comply, just be ready to pay a heap to the government. This is why complying with 409A valuation safe harbor is the easiest and cheapest way to go.
How do I get a 409a Valuation for my company?
You have three options through which you can get a 409A valuation report:
- Do it by yourself: This is the riskiest option of the three should the IRS be involved as there is no safe harbor protection. This means you have to prove that the valuation you did is correct. You may save some money in doing so, but there will always be mistakes unless you are an expert and have the experience, education, and knowledge needed to do a 409A valuation.
- Use software: Doing this is the same as doing it by yourself as it is also risky. Even though it is a cheaper option and may be more accurate than doing it by yourself, it also lacks the safe harbor protection that most companies look for.
- Hire a qualified firm: This option is the safest and least risky of all as it provides 409A valuation safe harbor status. This means that the IRS has to prove that your valuation is low, instead of you proving its the correct figure. For this, it is essential that you find a firm with the experience, knowledge, and a good reputation. However of course it does come with its own costs.
What consequences should I face if I violate a 409a Valuation?
When you do not do the valuation with one of the approved methods to provide you safe harbor, it could be bad for your company. Not pricing your stock options properly will be perceived as just giving away something to option holders, and will lead to tax issues. If you are handed out penalties, it could be substantially burdensome for the shareholders and the employees. They include:
- 20% additional tax on all deferred compensation
- The revised taxable amount will be higher as the accumulated interest is added
- All deferred compensation from the preceding and present year becomes taxable instantly.
Even though every startup does not face the IRS, it’s better to not take a chance. Also, if your company grows and reaches a significant changing point (acquisition, merger, or IPO), you may face audits. From the beginning, this will help you save time and effort if you work with a good valuation provider.
409a valuation reports with Eqvista
The best way out of the fines and penalties is to comply with 409A valuation rules. In the current world of employee equity compensation and stock options, the 409A valuation impacts the shareholder value in a positive way which encourages them to adhere to the rules.
The best thing to do is get the 409A valuation from a trusted firm that has the right knowledge and reputation. At Eqvista we offer quality 409a valuations at an affordable price.