When you offer stock options or equity grants to employees, you must pay attention to IRS regulations to ensure that you assign an accurate value to those grants and follow proper reporting procedures. One critically important element in that process is a proper 409A valuation–that is, establishing the value of an enterprise based on a clearly defined set of rules and attributes.
You must calculate 409A valuation correctly and with absolute confidence because the cost of getting it wrong can be significant. IRS penalties imposed on your employees may include 20% on all deferred vested amounts, plus an above-market rate of interest. Additional penalties could accrue if employees under-report their income as a result of a flawed 409A valuation report. State tax authorities may impose even more penalties on your employees. Penalties and interest could be assessed to shareholders if your company fails to correctly adhere to 409A reporting requirements. Needless to say, 409A errors can be very costly, not to mention embarrassing.
What is 409A Valuation?
The American Jobs Creation Act of 2004 established Section 409A of the Internal Revenue Code. Its primary purpose was to clarify the rules surrounding nonqualified deferred compensation, including stock options. The law emerged largely as a response to the Enron scandal, in which corrupt company executives converted deferred compensation to cash shortly before the company went bankrupt. The law covers a broader range of issues surrounding deferred compensation, with important implications regarding equity compensation.
A 409A valuation establishes the fair market value of a company and by extension, its common stock. In essence, the IRS has provided a framework for establishing market value. Companies may choose from multiple valuation methods.
409A Reporting Requirements
If you offer equity compensation to your employees, or if you plan to, then you will need a 409A valuation. The law requires private companies to generate a new 409A valuation at least every 12 months, or whenever a so-called “material event” occurs. That typically includes anything that could substantially impact the value of the company’s stock, including closing on a new round of investment, for example. Likewise, if the company anticipates an IPO, a merger, or an acquisition in the near future, then a new 409A valuation report may be in order.
IRS rules require that an external auditor be engaged to review each 409A valuation. Companies also have the option of outsourcing 409A valuation reports to an independent third party. This brings with it an important additional benefit, namely that under most circumstances, it provides a “safe harbor” presumption with the IRS that the valuation is reasonable and may be relied upon.
Valuation and Reporting Methods
There are several different methods available for establishing a company’s market value under 409A. The three most common approaches are market value (also known as the OPM backsolve method), the income approach, and the asset approach:
- The market value (OPM backsolve) approach may use one of several different methods to arrive at a fair market value. If the company has recently closed a round of new investment, then it can be presumed that the investors paid what amounts to a fair market value for their equity. The market value approach adjusts for the fact that venture investors often receive preferred shares, and applies a formula to arrive at a fair market value for common stock. Another variation on the market value approach is to look for comparable publicly traded companies, assess the value of those companies, and adjust for differences in size, revenue, and target market to arrive at a fair market value for the company in question.
- The income approach applies a discounted cash flow or analysis to estimate the net present value of cash flows that a company is expected to generate in the future. In other words, it establishes the value of the company based on its expected future income. This is more appropriate for valuing businesses that have an established income stream and generate positive cash flow, or are at least expected to be profitable in the near future.
- The asset approach is based purely on the net asset value of a company. This is most appropriate for very early-stage companies that do not have a track record with a successful product launch and have little or no established income stream.
What Information is Required for a 409A Valuation?
Whether you choose to produce a 409A valuation report in-house or to outsource it to an expert third-party, you will need to gather certain information in advance to prepare for the valuation:
- Company details, including the names of your CEO, legal counsel, and external auditors
- Which industry or business sector your company operates within
- Most recent (updated/amended) articles of incorporation, corporate charter, or certificate of incorporation
- Your most recent capitalization table (“cap table”)
- Information about recently closed investment funding rounds (including board presentations, pitch deck, etc.)
- Company financials, including the last 3 years’ income statements, balance sheets, statements of cash flow, forward-looking cash flow and debt projections.
- An estimate of expected stock options to be issued within the next 12 months.
- If using the market value approach, a list of five or more publicly traded companies in the same business, preferably with a comparable product, target market, and revenue.
- A list of potential future “liquidity events” such as IPOs, acquisitions or mergers, etc., including their timing.
- A list of significant events that have occurred since filing your most recent 409A, including new rounds of funding or other material events that could impact valuation.
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