What is a 409A valuation, and why do you need one?
- 409A valuations determine the fair market value of private company stock so equity compensation complies with IRS rules.
- Accurate valuations protect employees and companies from significant tax penalties and compliance risk.
- Using a safe harbor valuation shifts the burden of proof to the IRS and reduces risk.
When starting a business, cash flow can be limited. Employee salaries can take up a lot of your much-needed cash flow. If a company wants to utilize the best talent but can’t pay them the going wage rate, they may provide a future incentive to entice employees to work for less — and part of that incentive could be in the form of equity in the company.
Equity-based compensation (also called deferred compensation) allows founders/owners of startups to provide meaningful, fair compensation to employees without using much-needed cash.
What’s more, equity-based compensation also serves the purpose of aligning the interests of ownership and employees. It makes employees stakeholders in the future value of the firm, thereby incentivizing them to do what they can to increase value.
But how do you offer employees a piece of your company if you don’t know what it’s worth?
The 409A IRS code governs deferred compensation, and it stipulates that a valuation is required any time you are going to be giving out equity in your company over a period of time. IRC 409A includes the rules you need to follow to determine the fair market value (FMV) of your common stock.
Here’s what you need to know about 409A valuations to support equity-based compensation:
What is a 409A valuation?
A 409A valuation is an independent appraisal of a company’s common stock to determine the fair market value.
What is a 409A valuation used for?
A 409A valuation is primarily used to set the tax basis for non-qualified stock options.
Over time, if a company does well, its shares will gain value. An employee’s taxes will be based on the difference in value from the time the shares are granted to the time they receive them or sell them.
For example, consider a startup looking to hire a software developer. In order to attract that kind of high-value talent, they offer the employee the option to buy 5,000 shares at the current fair market value, which is $2.00 per share.
Under their agreement, the developer can exercise those options after three years of employment. Once three years have passed, the shares become worth $10.00 each. The developer can exercise those options, buying shares worth $50,000 for the price of $10,000 (5,000 x $2.00).
A 409A valuation is necessary to determine that the options offered to the developer are appropriately priced at $2.00. Under IRS regulations, you cannot just guess and make it up. It needs to be reasonable and defensible. Otherwise, companies could use this kind of equity-based compensation to hide shareholder income.
When to get a 409A valuation
A 409A valuation is needed when:
- You need to perform your annual valuation update: According to the IRS, 409A valuations remain valid for one year.
- Material events impact FMV: Companies are expected to update 409A valuations within approximately 90 days of a significant event that’s likely to impact the value of their common stock. This includes events such as an M&A, new financing rounds, product launches or changes in capital structure.
What is a 409a valuation report?
A 409A valuation report is a formal document prepared by a qualified valuation firm that determines the fair market value (FMV) of a private company’s common stock for compliance with IRS Section 409A.
How much does a 409a valuation cost?
A 409A valuation price depends on the complexity of the valuation. For example, early-stage, i.e., pre-seed or seed startups, typically see lower costs than mature companies, which usually require a more detailed and extensive analysis.
409A valuations: Avoiding penalties
Misprice your stock options and employees could significant repercussions. If the IRS determines you granted options below fair market value, they’ll levy an immediate tax on the employee for the full value of the award plus up to an additional 20% penalty.
For example, consider if you granted 5,000 options at a strike price of just $1.00. Four years later, the IRS determines you used a flawed valuation approach, and the common stock should have been valued at $2.00.
Here’s what your employee could owe in that tax year:
| Option strike price: | $1.00 |
|---|---|
| FMV in year three: | $10.00 |
| Number of vested shares: | 5,000 |
| Taxable income: | $45,000 (5,000 shares x $9.00) |
| Federal income tax: | 32% (assumes mid-range tax bracket) x $45,000 = $14,400 |
| 20% penalty: | $9,000 ($45,000 x 20% for prior year’s vested options) |
Because the stock options were not granted at fair market value, your employee will owe $23,400 to the IRS — even if they didn’t exercise their options! And that’s only the federal tax liability.
These are steep penalties to the employee. Even if you can find a way to make them whole — through all the withholding and reporting penalties — you will have shaken their trust and likely won’t have these high-value employees around much longer.
The stakes are high, but penalties are largely preventable. Establishing a 409A valuation that meets safe harbor standards is the most effective way to protect employees from these outcomes and shift the burden of proof away from your company.
What is a safe harbor valuation?
Under 409A regulations, companies have options to obtain a “safe harbor” valuation. A safe harbor valuation is presumed to be correct because you did it through the proper framework.
What that means is that if, at a later date, the IRS says, “We think that valuation was wrong. Your shareholders are making too much money,” the onus is now on the IRS to prove the valuation was inaccurate. Achieving safe harbor shifts the burden of proof to the IRS that the determined value was grossly unreasonable.
In order to achieve safe harbor, the 409A valuation must:
- Meet specific internal criteria or be performed by an independent third party.
- Be updated every 12 months or after a material event.
- Use recognized valuation methods.
3 ways to reach a safe harbor valuation
There are three recognized valuation methods for safe harbor:
- Independent appraisal method: The valuation is determined by a qualified independent appraiser within the prior 12 months. This is the safest and therefore generally the most popular option due to the credibility and assurances provided by an independent specialist.
- A formula-based valuation: This method is only available to a few companies, as certain conditions must be met. Specifically, a) the stock must be subject to non-lapse restrictions (buy/sell agreements), which require the holder to sell it back to the company at the formula price, and b) the formula must be used consistently for compensatory and non-compensatory purposes in all transactions in which the issuer is either the purchaser or seller of the common stock.
- Illiquid startup method: For an illiquid startup (generally less than 10 years in business with not publicly traded securities) that is not anticipating a change of control in 90 days or a public offering within 180 days, a valuation can be considered safe harbor if it is completed by a “qualified” (but not necessarily independent) person who meets expertise/experience standards outlined by the IRS, is evidenced by a written report and considers relevant valuation factors such as the value of tangible and intangible assets, the market value of similar entities, control premiums, etc.
With all the restrictions and standards that must be applied to meet safe harbor qualification, it’s important that organizations have proper valuation and governance processes in place to ensure stock options are granted with the proper strike prices.
Hiring an independent appraiser to perform a 409A valuation is the easiest and safest way to establish safe harbor and protect your employees from future IRS penalties.
How Wipfli can help
Concerned your deferred compensation plan could fall under 409A guidelines? Wipfli has the professionals who can provide an effective safe harbor 409A valuation. Talk to our valuation services team today about how you can build confidence in your compensation plan.
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