Setting up a company is just one part of starting your business. When a company starts off, they are not worth much and are often cash strapped, so it’s tough to give good salaries to hire the best talents in the industry. In such a situation, it is normal for the company to compensate the employees with stock options. For this, the company has to comply with the related laws including getting a 409A valuation report for their company.
The Internal Revenue Code Section 409A was introduced to govern the way companies treat their “nonqualified deferred compensation”, ie. stock options and other equity awards. To get the strike price of the employee stock options, a 409A valuation is performed. These options have to meet the IRS requirements of having a proper FMV (Fair market value). Let us understand more about 409A valuation services and the 409A valuation report.
What is a 409a Valuation?
To be precise, a 409A valuation report is a valuation of a company, prepared by an independent appraiser, of the fair market value (FMV) of a private company’s common stock. The 409A valuations help private companies comply with Section 409A of the IRC that governs non-cash compensations (option grants and stocks).
Why is a 409a Valuation important for a company?
Section 409A gives guidelines that have to be considered before the issuance of options and shares. It lays out the regulatory requirements involved in the issuance process. This section came into being due to the prevailing pricing manipulations that took place in the 90’s and early 2000’s. At this time, companies would set a very low valuation for the shares internally to benefit from it.
409A is there to ensure that the proper federal income taxes are paid on time for deferred compensation plans. Along with this, it also ensures that the company options are protected by an IRS safe harbor. This means that the company has obtained the 409A valuation report as per IRS rules and is protected in case of an audit or possible penalties.
Not complying to these rules set by the government will result in you and your employees paying extra taxes for the stock. Along with this, you will also have to pay additional fines, which is normally about 20% of the total tax you needed to pay. Added to this is the interest on the payments as well. Not only will this make your employees very unhappy, it would also put the future acquisition plan of your business under risk. This is because no one wants to deal with indemnities and tax risks that the company has by not following the tax code.
This just makes getting a 409A valuation report from a professional 409A valuation provider that much more important. It is something you cannot ignore just because you want to save a little. The act of trying to save money by ignoring the 409A valuation requirements would lead to unforeseen risk and possible penalties down the road for both the company and its employees. Better to spend a little now than a lot later.
When do you need a 409a Valuation?
There are several events when you need to get a 409A valuation service, which include:
- When you are about to give out stock options to your employees. You need a 409A valuation report so you can put the right strike price on the options before the issuance process.
- You also need to get a 409A valuation report every 12 months. The reason is so that you know where your company stands. And it also offers the 409A valuation safe harbor status during the vesting period of the option plans. Since the vesting plan would normally last several years, it is important to know the value of the options each year. This is why a 409A valuation is needed.
Sample of Eqvista 409a Valuation Report
Here we have included a sample of our 409a valuation report of a mock company for viewing purposes.
As you can see, our 409a valuations are fully customized for each company, with easy to understand charts and tables about the information pertaining to your company valuation. We strive to provide the highest quality of 409a valuations in the market, while also maintaining a report which is understandable for our clients.
As our valuation reports are usually 50+ pages for a single 409a valuation, you can rest assured that the process to find the fair market value of your company is accurate with safe harbor status from a trusted independent appraisal company.
409a Valuation Safe Harbor
The common stock of every company is subject to constant change. So, it is very difficult to get the exact value of the shares at every single point of time without undue burden. Due to this, the IRS offers a certain “Safe Harbor” status that is obtained by using their specific methodologies to get the Fair Market Value of the common shares of the company. These methods include:
- Independent Appraisal Presumption: The most commonly used method and the valuator preparing this is compensated with a fixed amount and is not based on the result of the appraisal. If all the requirements are met, the burden of proof is on the IRS for this approach.
- Illiquid Startup Presumption: In a few cases, the company can choose to get the 409A valuation report prepared in-house. This is possible only if the following are true:
- The stock is not subjected to put or call rights.
- The company isn’t anticipating any IPO, sale, or change of control in the next one year.
- The company is a private company and is not more than 10 years old.
- The person valuing the company has the needed experience and knowledge or training to perform the valuation (at least 5 years of relevant professional experience)
- Binding Formula Presumptions: It is also possible to get the 409A valuation done by using a single formula which is marked to a tangible benchmark such as the Net Income, EBITDA, or Sales, that is applicable to all binding agreements. But this method also creates many restrictive conditions.
In case you have used one of these mentioned methods to get the 409A valuation report, your valuation would be considered to be valid by the IRS. This means that the burden of the proof is on the IRS where they would have to prove that the value is “grossly unreasonable”.
Nonetheless, if these methods are not used to obtain the 409A valuation report, the safe harbor status would not be applied. And then the burden of proof shifts to the taxpayer to show that the value of the shares is correct. So, even though you can do the valuation on your own, you will have to make sure you are following the guidelines of the IRC section 409A.
Just so you know, there are penalties that the IRS imposes on the taxpayer if the rules of the 409A valuation are not followed. The penalties would be applied mostly when you undervalue the FMV of the business and get a low strike price. In fact, if you do not use the methods mentioned above to get the valuation report, you would fall outside the 409A safe harbor. And if the IRS audits your business and sees that the strike price is lower than normal, penalties are handed out.
The employees who have the stock options would be taxed instantly with the regular income tax the moment the options vest. And if the employees are not able to pay the income taxes, more penalties are added to it. In addition to this, there are more penalties for both the shareholders and employees, including:
- All the deferred compensation would become taxable instantly
- Accrued interest on the revised taxable amount
- Extra tax of 20% on all the deferred compensation
- State taxes and penalties, based on the state in which the company is in
- The IRS tax underpayment penalty along with an additional 1% penalty
Get your company 409a Valuation Report with Eqvista
Reduce your risk of exposure by getting a professional and correct 409A valuation for safe harbor by a reputed 409A valuation provider like Eqvista. Eqvista has a team of experienced valuation analysts who have performed valuations for the companies of all stages and sizes. For each valuation, one dedicated analyst handles everything from gathering the information and sharing updates to answering your questions. And the final 409A valuation report that you get would be audit-ready, accurate, and completed in a short-period of time.
The pricing of the 409A valuation report offered is based on the stage in which your company is in. Eqvista offers 409A valuation services for every funding stage in a business. Our basic packages start at $1,100 for seed stage companies. Checkout our 409a valuation price list here!
All you need to do is contact us and we’ll let you know more about getting your company’s 409A valuation report!