Issuing stock options to employees can be a great way to reward and motivate good performance, and many of them will gladly take them. In some cases, such stock options can also confer tax benefits. However, in order to ensure that appropriate taxes are paid on all deferred compensation and stock options, the IRS requires that private companies secure a valuation of these shares. 409A valuations are vital for every company to conduct properly, even early stage startups, in order to avoid serious penalties at a later date.
Anyone who is considering offering shares to employees as a form of compensation should first speak with a corporate lawyer while the employees each speak with their own tax lawyer. Section 409A applies to any and all companies that offer nonqualified deferred compensation plans to their employees, which includes appreciation rights, stock options, retirement plans, and any other employee grant. Itís important to know where you stand by getting a 409A valuation before you can begin to offer 409A.
What is a 409A Valuation?
A 409A valuation is simply an appraisal of the fair market value of a companyís more common stocks. This name comes from IRS Section 409A. The section, added with the American Jobs Creation Act in 2004, states:
ìSection 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.î
Stock options are considered deferred compensation. A 409A valuation will determine a “strike price” (the price at which your employees can buy equity in your company) that must be at or above fair market value.
IRS Section 409A states that all private companies which issue employee stock option or any other deferred compensation must have a fair valuation. It doesnít matter if the business is a startup or a company like Amazon; it is required all the same. On top of this, you have to update your 409A valuation if there is a material change event which could alter the value of your stock. Material change events include receiving a term sheet for financing, receiving new financing, settling a lawsuit, or filing a patent. Valuations must also be updated based on elapsed time, even if there is no material change event. Generally, assuming there are no material change events, the valuation will be valid for 12 months. After 12 months the company must be reevaluated. As well, this must be done when a new funding round is closed.
What Factors Influence Your 409A Valuation?
The IRS states that fair market values are able to be determined via a reasonable application of a reasonable valuation method. Further explanation is that so long as a method is applied consistently and reasonable the valuation will be accepted. Consistency in application is assessed by reference to the valuation methods used to determine fair market value for other forms of equity-based compensation. Itís been stated that any independent appraisal is to be considered reasonable is ìthe appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.î
One of the below approaches will be used by firms that are determining the 409A to then appraise the fair market value:
This method appraises the value of your asset by comparing it to the price of similar items. This market approach is used for the valuation process for tightly held businesses, or for the calculation of property value. Additionally, the market approach can be used to determine the value of a business ownership interest, security or intangible asset. Regardless of what asset is being valued, the market approach studies recent sales of similar assets, making adjustments for differences in size, quantity or quality.
This approach is worth looking at because it uses actual prices and transactions related to companies that are in the same or similar industries in order to assess the value. Both the purchasers and vendors operate on the basis of expected future benefits associated with shared ownership.
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There are two areas that require attention for accurate valuation:
Are the comparable companies used as guidelines truly comparable to the company in question, or are there better examples to compare and contrast with?
Are the right valuation multiples derived from the stock market actively being applied to the parameters of the subject company?
The value of a property is calculated in this method by dividing the net operating income (NOI) of the collected rent by the rate of capitalization. In order to determine the NOI an investor will take comparable properties and look at their market sales.
After a capitalization rate has been determined, the propertyís characteristics must then be taken into account and be used to adjust the rate. For example, the property may have higher-quality tenants than other nearby properties, which would slightly reduce the capitalization rate. On the other hand, the property may be less appealing than others in the area, which would slightly increase the rate. The capitalization rate should be set within 50 basis points of the market average.
The income approach is typically used for income-producing properties and is one of three popular approaches to appraising real estate. The remainder will use the comparison or the cost approach.
The income approach looks to see if a return of investment can be done by the business having a steady enough cash flow from its operations. The method can capitalize or discount the assumed maintainable post-tax cash flow in the future based on the operations by a rate of return. Future potential purchasers will use this number to help calculate their risks and understand the rate at which their investments into the property can be reasonable expected to be returned.
The two variables that are used in this method above others are the future cash flow and the risk taken to earn that cash flow back. The better you manage these variables, the most likely youíll receive a favorable 409A.
An asset-based approach is a type of business valuation that focuses on a company’s net asset value (NAV), or the fair-market value of its total assets minus its total liabilities, to determine what it would cost to recreate the business. When it comes to deciding which of the two categories an item fits in, and how much itís worth in that category, there are some variables, and as such the value being calculated is a bit subjective.
The conclusions made will affect the net tangible assets, and thusly the overall business value, as that is a key factor in deciding it. Buyers may become interested in a company because of its availability vs. security with regards to financing of it, or they might view the risk of something like bankruptcy to be easily handled due to the large amount of physical assets which can be liquidized.
How Do I Get a 409A Valuation?
You can choose to receiving your 409A valuation report from one of three different means:
Work with a firm: This method is the safest, and thusly the most prefered. It shifts the burden of proof onto the IRS in order to determine your 409Aís value. The IRS must back it, regardless of the outcome. This method costs the most, however you are essentially future proofing your business against the IRS itself, so the investment seems worth it.
Use a Program: You take a lot of risks with this one. This option is only available to certain early-stage startups, having to meet strict criteria, such as being able to prove the you havenít raised $500,000, lack a consistent revenue, not within 180 days to an IPO, not within 90 days to an acquisition, or having less than $100,000 in assets.
Do it on Your own: The riskiest option is to file the 409A valuation yourself. There are no safe harbors for you should you make a mistake. Sure initially you can save some money, but when the IRS decides your valuation needs some reevaluation youíre going to be paying a whole lot more. Either you should be very well versed in 409A valuations and all things related, or you can simply leave this to the professionals.
Some of the most common mistakes made during a 409A valuation:
Hiring an inexperienced appraiser. Cheap firms donít necessarily provide a good service. Be sure that you only hire reputable firms.
Not taking your accountantís input ahead of choosing appraisers. If there is an audit performed by the IRS then theyíll be working with your accountants quite closely, so itís best theyíre aware of these sort of happenings.
Pushing your appraiser. Even if you want them to give you a lower strike price you should remember that they can refuse to defend your 409A valuation in the case of an IRS audit, or even flat out refuse to issue the valuation report in the first place. Itís best you donít let your relationship fall on bad terms.
How long does a 409A Valuation Take?
Considering the many factors involved itís difficult to pinpoint a return time for the 409A valuation. However, you can generally expect the following time frame:
Provide your data (1-3 days): This includes your articles of incorporation, cap table, financial projections, past 409A reports, and financial projections.
Run the report (10-20 days): If you require a quicker valuation then you can expect to pay a minimum of $1,000.
Revisions (1-2 days).
Youíll receive the final report (1-10 days).
At the worst it may take just over a month for you to get all of the needed information put together and get a finished 409A valuation back. However, if there are errors or the IRS has to get involved then this may take even longer. By hiring a firm youíd be able to minimize the errors, and thusly speed up the process as a whole. Youíll need to be accurate for the time frame.
What if I donít have a 409A Valuation?
Essentially no valuation means you get to live through a horrible nightmare. If you donít price your stock options, the IRS treats it as though the company is just giving away assets. If an option holder is found to be violating 409A then theyíll have to pay IRS tax underpayment penalties, unpaid taxes, state penalties, and the interest on unpaid taxes. Service recipients are responsible for normal withholding and reporting obligations with respect to amounts includible in the service providerís gross income under Section 409A. For the holder of a stock option, this can be particularly troublesome, since an absent exercise of the option and sale of the underlying stock means that there has been no cash received with which to pay the taxes and interest.