409A Education

What Is 409A?

409A refers to Section 409A of the Internal Revenue Code for the Internal Revenue Service (IRS) of the United States of America. This code governs the taxation of non-qualified deferred compensation paid by a "service recipient," typically a company, to a "service provider," typically an executive employee, general employee, independent contractor, or board member.

The IRS originally drafted the 409A language to safeguard against the problems with deferred compensation that occurred at places like Enron and Worldcom. Those companies were taking advantage of tax loopholes and backdating stock option grants to provide executives with huge gains and very small tax bills. To prevent this, the government spelled out several ways that you can grant deferred compensation without triggering significant penalties. One of the key requirements to avoid creating tax penalties is to grant stock options with a strike price at (or above) the fair market value of the underlying security, which is typically the fair market value of the target company's common stock.

What Is a 409A Valuation?

A 409A valuation is a valuation of a company that establishes the fair market value of the common stock. Knowing the fair market value of the common stock allows the company to set the strike price of its common stock options equal to the value of their underlying security, common stock. By setting the strike price of new options equal to the price of the common stock you avoid onerous tax penalties that you would otherwise incur.

Do I Have To Get a 409A Valuation?

No, you do not have to get a 409A valuation. However, many, if not most, companies granting stock options will probably want to get one. If your company fails to comply with 409A, your employees will be personally liable for immediate taxation plus a 20% penalty tax and possible interest payments. So most companies granting stock options consider 409A valuations to be part of the cost of granting those options.

How Do I Get a 409A Valuation?

You’ve come to the right place! We can offer a full-range of 409A valuation options and foster competition between providers so that you will get the best valuation based on the factors that are most important to you.

Are There Different Kinds of Valuations Available?

Yes, based on your stage, desires to minimize cost, and your appetite for risk, there are many options available to you now. Recognizing that 409A could create unintended and unnecessary burdens on small startups, the IRS created a specific safe-harbor provision for "illiquid startups." "Safe harbor" refers to a provision in 409A that requires the IRS, not the person or persons performing a valuation, to prove that the valuation is "grossly unreasonable" in order to challenge it. In other words, if you qualify for safe harbor, you have enormous protection against the nasty penalties that result in non-compliance with 409A.

Types of 409A Valuations

Most companies will want to take advantage of safe-harbor protections. However for some of the earliest stage companies, it could make sense to use other alternatives to estimate the fair market value of common stock. Companies worried about risk in this scenario can also increase the strike price above what they think is reasonable in order to decrease the risk of being out-of-compliance with the 409A provisions. Lastly, just because a company's valuation is not in safe-harbor does not mean that the valuation is wrong. Some companies push off the cost of a safe-harbor valuation to a time when they are being audited. They recognize that, at that time, they may need to incur additional costs by re-examining earlier valuation work. However, it may be worth it to these companies because when they are initially starting up, they have little or no money to spend on expensive valuation work.

Safe-Harbor Valuation Options

Safe-harbor valuation options typically cost in the thousands of dollars. Some valuation service providers will offer to ensure that your valuation stays accurate indefinitely for a monthly price. Others will require payment up front and charge for the valuations they provide. Typically, you can compare prices by comparing annualized numbers. Safe-harbor valuations range in price from $200 if you can do it yourself to $5,000 if you use a mid-range valuation services firm. Companies that are preparing for an acquisition or IPO will often seek out valuation firms with impeccable credentials and reputations. These firms can charge up to $20,000 + in annualized fees for their valuation work.

Valuation Services Firms

The safest of the safe-harbor options is to work with a valuation services firm. These firms hire qualified appraisers and their entire business hinges on making sure that you achieve safe harbor. They are skilled at defending their valuation work in front of auditors, which can save you and your company significant time and money. Most venture-backed companies, audited companies, and companies with sophisticated boards of directors will choose this option. These companies typically do not want to deal with the potential risk of a bad valuation and they typically have enough cash to be able to pay for a safer option. Also, the IRS requires that companies that expect an IPO or exit within 6 months seek out and use independent valuation services firms to do their 409A valuation work to achieve safe harbor. They are considered out of safe harbor if they perform valuations in any other way.

Do-It-Yourself

If you consider yourself a "qualified individual" to perform valuation work, then the IRS made it clear that if you are a "qualified individual" you can still claim safe harbor when performing your own valuation. When industry participants pushed the IRS for more information about whom the IRS would consider a "qualified individual", the IRS clarified that the ultimate standard is whether or not a company might "reasonably rely" on the qualified person as someone who has the requisite expertise to perform such a valuation. Specifically, the IRS stated, "Because knowledge, skill and training may be obtained in different ways, the final regulations do not provide specific examples. However, the regulations clarify that the standard to be applied is whether a reasonable individual, upon being apprised of such person’s relevant knowledge, experience, education and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued." Previous discussions about who is qualified to perform 409A valuations has included people like venture capitalists, experienced startup CFOs and accountants, and outsourced CFOs.

Increasingly, companies like Capshare offer “Turbo Tax”-like software that facilitates inexpensive but high-quality valuation work.

Non-Safe-Harbor Valuation Options

Non-safe-harbor valuation options are riskier but significantly less expensive. Some of these valuation options can cost as little as $500 versus thousands of dollars for safe-harbor-valuation options.

Guestimating

While risky, it is possible for a nascent startup to simply guess at the value of their stock. If the company is small, has not raised capital, has a high likelihood of failure, and has had no significant value creation events, it is sometimes possible to just assign common stock a low value per share. Companies opting for this approach can decrease their risk by simply increasing the estimated value / share and the strike price of their options. For example, assume that the founders of a company believe their own company is mainly "just an idea" and therefore is worth max $50,000 and they have created 1,000,000 common shares. In this case the stock would be worth $0.05. However, to decrease their risk, they could just arbitrarily increase the value they assign to their company by a factor of 5, and assume that their company is actually worth $250,000, something they are 99% confident overstates their value. Since the IRS is concerned that companies are undervaluing themselves when they grant options, it is safer to assume a higher valuation for your company. So, back to our example, if the founders assume their company is worth $250,000, their stock would be worth $0.25. At $0.25 / share, the founders believe that they are at relatively low-risk for an IRS audit. Further, choosing a strike price between $0.05 and $0.25 allows them to choose their own level risk. The higher the assumed valuation / strike price, the lower the risk of non-compliance with 409A.

Do-It-Yourself Software

Increasingly companies like Capshare offer "Turbo Tax"-like software that guides you through the process of performing a valuation. The IRS also makes it clear that if you are a "qualified individual" you can still claim safe harbor when performing your own valuation. When industry participants pushed the IRS for more information about whom the IRS would consider a "qualified individual", the IRS clarified that the ultimate standard they would apply here would be whether or not a company might "reasonably rely" on the qualified person as someone who has the requisite expertise to perform such a valuation. Specifically, the IRS stated, "Because knowledge, skill and training may be obtained in different ways, the final regulations do not provide specific examples. However, the regulations clarify that the standard to be applied is whether a reasonable individual, upon being apprised of such person’s relevant knowledge, experience, education and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued." Previous discussions about who is qualified to perform 409A valuations has included people like venture capitalists, startup CFOs and accountants, and outsourced CFOs.

Software with Support from Valuation Software Experts

Companies like Capshare also offer valuation software experts who can guide you through the process of performing a 409A valuation. These experts have significant experience performing these valuations. However, they will not sign a valuation report or take liability for ensuring that the company achieves safe-harbor.

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