Creating ESOP for your Startup: How a 409A valuation can help?
The term “409A value” is derived from Section 409A of the United States Internal Revenue Code, which governs nonqualified deferred compensation schemes (e.g., stock options). The legislation compels private corporations to set an exercise price for their stock that may never be less than the FMV of the underlying stock on the date the stock right is given. An employee benefit plan is the Employee Stock Option Plan (ESOP). It is given to employees by the corporation to foster employee ownership of the company. Employees are given reduced shares in the companies they work for.
409a valuation and ESOP in startup
A 409A valuation is the fair market value of a private company’s common stock as determined by a third-party appraiser. Startups require 409A valuations in order to provide employees tax-free stock options. The 409A valuation defines a company’s common stock’s base price, which is used to determine the price at which workers can exercise their stock options. An employee stock ownership plan (ESOP) is a method in which a company offers to increase its subscribed share capital by issuing extra shares to its employees at a predetermined rate. The Employee Stock Ownership Plan (ESOP) benefits both the company and its employees. It encourages startups by allowing employees to be rewarded after the company is publicly traded.
Understand 409a valuation and its importance
A 409A valuation is an estimate of your new company’s common stock’s fair market value. It’s simple to view the particular pricing with publicly traded stock at any given time of day. Private business stock, on the other hand, private business stock requires an independent assessment to determine its value. Section 409A of the Internal Revenue Code is the source of the 409A. To guarantee that your organization is in compliance, you’ll need a 409A valuation. Non-compliance can lead to disastrous results. Stock option undervaluation can result in significant IRS penalties and missed compensation.
What is ESOP?
Employee stock ownership plans, or ESOPs, are a type of employee stock ownership plan. An ESOP is a retirement plan that gives employees of a firm a share of the company’s ownership. Companies grant stock ownership to their employees through an ESOP, often at no cost to the employees. ESOP shares, on the other hand, are part of an employee’s remuneration for work done. Employees are given ESOP shares, which they can keep in an ESOP trust until they retire or leave the company. After that, the shares are sold. ESOPs are governed by the Employee Retirement Income Security Act (ERISA), federal legislation that establishes basic rules for private-sector investment programs.
How does ESOP work?
Employee stock ownership plans, or ESOPs, are a tax-advantaged mechanism for employees to own a portion of their company through a trust fund. Companies contribute to the ESOP via tax-deductible donations. Contributions to the ESOP are either put into participant accounts or utilized to repay the ESOP debt. A portion of the shares is allocated to participant accounts when a portion of the ESOP debt is paid. Every year, ESOPs distribute shares to qualifying employees, providing them a greater ownership stake as they advance in their careers. Employees receive these shares through the ESOP in order to support their retirement. All ESOP guidelines strike a balance between two competing interests: flexibility enough for employers to be ready to set up an ESOP, but not so flexible that they can be abused.
What is an ESOP firm worth?
In the hands of employees, ESOPs are taxable as perquisites (salary income). The difference between the stock’s fair market price on the day the option is exercised and the price at which it is exercised is the value.
How does ESOP help grow startups?
At ESOPS, for startups, profits are higher with lower rates since they assist employees in obtaining desirable stocks at a cheaper cost. Employees can then decide whether to maintain these stocks for long-term gains or sell them at a higher market value to profit from their stock ownership. ESOPS for startups have an additional source of income: Employees who become shareholders have a say in how the company is run. They also get a dividend on their stock holdings, which is a source of additional income. Employees benefit from job security as a result of the vesting period, which promotes employee pleasure. ESOPs for startups are taxable. Allocating ESOPs to potential workers has no tax implications. If you spend money on ESOPs, you can deduct those costs from your firm revenue as a tax deduction.
Example of ESOP
Let’s say your firm has provided you with 100 ESOPs possibilities. The vesting period is three years, with a two-year exercise period in between. The Exercise Price (that is, the amount you must spend) is $50. The share’s current value is $150.
The vesting period ends at the conclusion of Year 3, and the employee can now convert his or her options into shares by paying the exercise price of $50.
The employee will now be the owner of 100 shares after paying the exercise price of $50 x 100 = $5000. And once the employee has the shares, he or she is free to sell them at any moment, just like any other stock.
How does a 409a valuation help create ESOP in a startup?
Section 409A lays forth the rules that must be followed prior to the issuing of both shares and options, as well as the regulatory criteria that must be met. It was implemented in reaction to widespread pricing manipulations by Enron and other large corporations during the 1990s and the first half of the last decade, who frequently misused the prior approach of internal value setting. The 409A statute is primarily intended to ensure that adequate federal income taxes are paid on deferred compensation schemes, but it also assures that company options are protected under the IRS safe harbor.
Calculate enterprise value
We can calculate the enterprise value by using these approaches which are as follows:
- Income approach – The income technique, also known as the discounted flow method, analyses the company’s long-term financial projections to determine expected income levels, which are then discounted back to present value.
- Market approach – The company is compared to a group of publicly traded companies in its industry that are similar to it. This appraisal aids us in arriving at a quantitative figure for the company’s worth. In other words, it’s a road map for firms to follow when it comes to valuing their private shares.
- Cost approach – To establish the enterprise value of a corporation, this method employs replacement costs or the appraised value of all of the company’s assets and liabilities.
Determine the FMV of common stock
The 409a valuation is a third-party assessment of a firm’s common stock 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 own stock.
- Option pricing method (OPM) – Option pricing theory calculates the value of an options contract by allocating a premium based on the calculated chance that the contract will expire in the money (ITM). Common shares would have significant value under this method solely to the extent that residual equity value remains after the preferred stock’s liquidation preference is satisfied at the time of a liquidity event. The OPM often uses the Black-Scholes Option Pricing Model to price the various call options.
- Probability weighted expected return method (PWERM) – The Probability-Weighted Expected Return Method is a multi-step method for estimating value based on the probability-weighted present value of distinct future scenarios. First, the valuation expert consults with management to evaluate the range of possible future outcomes for the company, such as an IPO, sale, dissolution, or continuation of operations until a later exit date.
- Hybrid method – The PWERM and the OPM are combined in the Hybrid Method. It employs probability-weighted scenarios, but with an OPM, it assigns importance to one or more of them. When a corporation has visibility into a specific departure path (such as a strategic sale), yet there are still uncertainties, the Hybrid Method may be used if that scenario fails. In this example, a PWERM with a probability assumption that the sale will go through might be used to estimate the value of the shares under the strategic sale scenario.
- Current value method – The Current Value Method subtracts the worth of the preferred classes based on their liquidation preferences or conversion values from the company’s total equity value on a controlling basis (assuming an instant sale). The remainder is subsequently distributed to common stockholders. Because the CVM is solely concerned with the company’s worth on the valuation date, it is unnecessary to make assumptions about future exit events and their timing. This method has the advantage of being simple to implement and not requiring a large number of assumptions or extensive modeling.
How to set up ESOP in a startup?
Businesses have employed ESOPs all over the world to encourage employees to buy shares and own a piece of the company while also tying their performance and hard work to the same. After fledgling start-ups struggled to attract sufficient human resources, the ESOP became popular. When start-ups are unable to deliver enticing offers to keep and expand their workers but are willing to partake in the company’s future success, they begin to lose employees.
- Prepare ESOP scheme – The first step is to have a professional design an ESOP plan for you. ESOP management, pool size, grants, vesting, employee cessation, exercise period, and other legal terms are covered in this scheme document.
- Valuation certification application – A Valuation Certificate is a certificate, in form and substance acceptable to the Required Lenders, signed by a Responsible Officer of the Parent, specifying a dollar value (rather than a range of values), dated as of the date of delivery, that certifies, at the time of determination, that the Parent’s assets are valued in dollars (rather than a range of values).
- Board approval – The next stage is to obtain board approval for the ESOP scheme’s adoption. The ESOP scheme must also be authorized by a special resolution at the shareholders’ meeting (EGM). You must first send out an EGM notice, after which you must hold the EGM and pass the shareholder resolution.
- Shareholder approval – Holders of a majority of the shares of Stock represented and voting in person or by proxy at an annual or special meeting of shareholders of the Company where a quorum is present are said to have approved the Company. Because ESOPs are just options, not shares, there is no need to increase the company’s authorized share capital at the time of ESOP issuance. It is only required when an employee exercises a stock option, which is normally considerably later.
- Start granting – ESOPs can be granted to your employees via a grant letter. We’ve seen founders try to send grant letters to employees that are backdated to a previous date since the employees were promised these benefits long before shareholders authorized the ESOP scheme. This is illegal since the grant date must precede the ESOP shareholder resolution date. On a day known as the grant date, eligible employees are given stock options.
Who and who doesn’t get the ESOP?
Employee stock ownership plans (ESOPs) allow employees to buy the business stock at a nominal price and sell it at a profit after a predetermined period of time (determined by the employer). There are countless success tales of employees raking in cash alongside the company’s founders. Every employee is eligible for an ESOP, with the exception of directors and promoters of a firm that owns more than 10% of the company’s stock.
How does the allotment of ESOP work?
It entails alerting the employee of his ESOP eligibility. The firm will have complete control over the exercise price, while employees will have the option of participating in an ESOP. Vest: The right of employees to apply for shares that have been issued to them. For the ESOP scheme, there must be a minimum of one year between the issuance of the option and the vesting of the option. Employees have the ability to exercise their stock options during the exercise period. The corporation will have complete control over the lock-in period for any shares issued (if any) after the option is exercised. Employees will not be able to receive a dividend, vote, or enjoy the benefits of a shareholder in the ESOP until the shares are issued as a result of his option being exercised.
Why choose Eqvista to determine Stock prices of common stock?
Getting the price of your company’s common stock can be tricky, and having a 409A valuation conducted can be a complicated process. To make the paperwork easier, it is advised to seek professional assistance when having a 409A valuation done. Eqvista offers one of the leading 409A valuation services, with customized reports and full customer support. Learn more about our 409A valuation and other business valuations by reaching out to us today!
