Stocks are a great reward for an employee, and theyíll typically be happy to receive them. Some stock options have the bonus of conferring tax benefits. The IRS has some rules requiring all private companies to secure a valuation of their shares if they plan to offer deferred compensation and stock options, to ensure that the correct taxes are being paid. 409A valuations are vital for every company to conduct properly, even early stage startups, in order to avoid serious penalties at a later date.
If you are considering issuing employee shares as a means of compensation, itís important that you consult with a corporate lawyer and that your employees separately consult with tax lawyers. Section 409A applies to all companies offering nonqualified deferred compensation plans to employees, including stock options, appreciation rights, qualified retirement plans and other employee grants. You need to understand where youíre at by getting a 409A valuation before you offer anything 409A.
What is a 409A Valuation?
409A valuations are appraisals of the current fair market value of a companyís common stocks. The 409A name comes from IRS Section 409A. Added in 2004 as a part of the American Jobs Creation Act is says:
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 fall under the title of 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.
Private companies that offer employee stock options or any other deferred compensation must have a fair valuation, as per the IRS Section 409A. It doesnít matter if the business is a startup or a company like Amazon; it is required all the same. As well if any material change event should occur, since it could alter the stockís value, then a new 409A valuation must be conducted. A material change event could be receiving new financing, settling a lawsuit, receiving a term sheet for financing, or filing a patent. Valuations must also be updated based on elapsed time, even if there is no material change event. In general, in the absence of a material change event, a valuation is considered to be valid for just 12 months. A new valuation must be conducted once the 12 months are up. As well, when a company closes a new funding round they will also have to do this.
Click here to read more about business valuation services in Los Angeles.
What Affects Your 409A Valuation?
In order for you to get your fair market value you must use a reasonable valuation method in a reasonable manner, according to the IRS. What this means is that the method must be and be done in a reasonable and consistent manner to ascertain an acceptable fair market value. The consistency is assessed by referencing the valuation methods that are used to determine the fair market value for the other versions of equity-based compensation. Independent appraisal will be considered reasonable if 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:
A market approach is a method of determining the appraisal value of an asset based on the selling price of similar items. This approach is a business valuation method that useful for calculation property value or as part of a valuation process for closely held businesses. Additionally, the market approach can be used to determine the value of a business ownership interest, security or intangible asset. Whatever it is, the market approach will assess the value by studying the recent sales of similar items and make adjustments for the variation in quantity, quality, or size.
The market approach is prospective because it uses value measures based on the prices of publicly traded stocks and the prices of actual transactions for the purchase and sale of companies in a certain industry or similar industries. Purchasers and vendors alike will operate based on the expectation of benefits in the future due to the association and shared ownership.
In order to have an accurate valuation you should keep two questions in mind:
Are the current comparable companies being used the best companies for the comparing and contrasting.
Are the correct multiples being taken from the stock market and being applied to the parameters of the company in question?
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. The market sales of similar properties are whatís used to determine the net operating income.
After a capitalization rate has been determined, the propertyís characteristics must then be taken into account and be used to adjust the rate. An example of this would be if your property has a higher quality tenant as compared to the properties in the area then the rate will be lower. On the other hand, the property may be less appealing than others in the area, which would slightly increase the rate. The rate should end up within 50 points of the average on the market.
The income approach is typically used for income-producing properties and is one of three popular approaches to appraising real estate. The rest are the cost or comparison approach.
The income approach looks at business operations that have the potential to grow or maintain the current cash flow from the daily operations, with the assumption any investment will receive a reasonable return. 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 main variables in this value would be the future cash flow and any risks involved in earning it. Youíll receive a much better 409A if youíre able to care for these variables.
Take your assets, minus your liabilities, and this will determine your companyís net asset value (NAV), in other words this approach finds the cost of recreating your business. There are multiple ways to interpret this number a there is some discrepancy in deciding whatís an asset, whatís a liability, and how much those items are worth.
The net tangible assets have a huge impact on the overall value of the business, meaning itís important to be careful with your decisions. Buyers may be interested in purchasing the property due to the large amount of easily liquidized physical assets, negating most of the fears with regards to a bankruptcy risk, or because the property has a higher availability to security when it comes to financing the acquisition.
How do You Acquire a 409A Valuation?
There are three options available to receive a 409A valuation report:
Work with a firm: This method is the safest, and thusly the most prefered. The burden of proving the value of your 409A is shifts onto the IRS. 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.
Personally do it: Youíre taking the most risks by going with this method. There are no safe harbors for you should you make a mistake. You may be able to save money doing it this way, but it can become costly later if the IRS steps in and deems your valuation to be faulty. Either you should be very well versed in 409A valuations and all things related, or you can simply leave this to the professionals.
Common mistakes made with 409A valuations:
Hiring an appraiser who is inexperienced. Cheap firms donít necessarily provide a good service. Ensure the firm you hire has a good reputation.
Failing to get input from your companyís accountants before choosing an appraiser. If the IRS performs an audit, they will need to work closely with your accountants, so keeping them in the know is key.
Putting pressure on the appraiser. You might want the strike price to be lower, but your appraiser can not only to refuse to issue your 409A valuation report, they can all refuse to defend the valuation should the IRS perform an audit. Itís best you donít let your relationship fall on bad terms.
How Long Does It Take to Receive My 409A Valuation?
There is no exact time to expect a 409A valuation to return, as there are many factors to take into consideration. Still, you should be able to use the following timeline:
Hand over your data (1-3 days): This will include your cap table, articles of incorporation, financial projections, term sheets, and past 409A reports.
The report is run (10-20 days): If you require a quicker valuation then you can expect to pay a minimum of $1,000.
Revisions (1-2 days).
The final report will be delivered (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. Keep in mind that if the IRS must become involved, or if there are mistakes made, then this process can be elongated. If you hire a firm, however, they can ensure minimal errors, and therefore speed up the entire process altogether. The timeframe is reliant on accuracy.
What if I donít have a 409A Valuation?
Essentially no valuation means you get to live through a horrible nightmare. Without pricing your stock options the IRS will assume that you are simply giving your assets away for free. Option holders that are violating a 409A have a list of payments theyíll be forced to make, including taxes, IRS tax underpayment penalties, state penalties, and interest on unpaid taxes. Service recipients will be held responsible for the normal withholding and reporting obligations as related to the amounts that are able to be included in the service providerís gross income, according to Section 409A. Anyone that is holding stock options will find themselves extremely irritated by this, since theyíll be unable to pay the taxes and interest if there is an absence in the exercise of the option and the sale of the underlying stocks.