Coauthored by Zach Liermann
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? Internal Revenue Code 409A 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.
409A valuation: The basics
409A is a framework that privately held companies can use when granting private stock options. Under 409A, equity-based awards need to be issued at or above FMV at grant date.
That valuation sets the tax basis for non-qualified stock options. Over time, if the company does well, those shares will gain value. The 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, let’s assume a startup is 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 — let’s say $2.00 per share.
Under their agreement, the developer can exercise those options after three years of employment. Now let’s imagine that three years have passed, and those shares are now 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.
3 ways to reach 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.
Here are three safe harbor valuation methods:
- Independent appraisal method: The valuation is determined by a qualified independent appraiser within the prior 12 months. This is 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 start-up 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.
409A valuations: Avoiding penalties
Misprice your stock options, and your employees could be in for a world of hurt. 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, let’s say you granted those 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:
|FMV in year three:
|Number of vested shares:
||$45,000 (5,000 shares x $9.00)
|Federal income tax:
||32% (assumes mid-range tax bracket) x $45,000 = $14,400
||$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 really 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.
Is your startup issuing stock options?
The bottom line is that 409A valuations are critical any time an employer hires someone under any kind of deferred compensation model. Concerned your deferred compensation plan could fall under 409A guidelines? Wipfli can help evaluate your compensation plans.
Companies should seek professional advice before granting stock options or equity awards to any employee or service provider. Wipfli has the professionals who can provide an effective safe harbor 409A valuation.
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