What’s a 409A valuation and why do you need one?

Startups are obliged to secure a formal valuation of their common stock prior to awarding options and other forms of equity compensation to employees and executives, and failure to do so can have serious adverse tax consequences for issuer and recipient alike.

Section 409A of the Internal Revenue Code sets out the requirement for privately held companies to determine a fair market value (FMV) for stock, with this valuation then to be used as the measure against which subsequent equity awards are priced.

This rule applies to all private companies, but in practice is particularly relevant for startups, who may use employee equity compensation as a key part of their talent recruitment strategy, as they will usually not be able to compete with more established competitors on basic salary.

Why do companies need a 409A valuation?

From the perspective of the Internal Revenue Service (IRS), the primary purpose of the 409A valuation requirement is to ensure that when companies offer stock options or restricted stock units (RSUs) to employees that they do so at a price that doesn’t overvalue that stock, i.e., setting a price in excess of the FMV.

Introduced as part of the American Jobs Creation Act of 2004, Section 409A was designed in part to tighten up existing regulations on deferred compensation and to minimize the leeway for actions that could exploit potential loopholes around equity compensation awards. Arising from this in the event of a company not abiding by the 409A terms, both the company and any recipients awarded equity at prices not formally linked to FMV will, in many instances, be deemed liable for tax-based penalties.

Securing a 409A valuation in an IRS-compliant manner, e.g., using an independent appraiser, makes a company eligible for ‘safe harbor’ status. In practical terms, this offers companies a certain measure of peace of mind, in that it demonstrates that they have made genuine efforts to establish the FMV of stock in a legally correct manner. In the event of any questions from the IRS at a later date, ‘safe harbor’ constitutes a robust defense.

How does the 409A valuation process work in practice?

The key to securing ‘safe harbor’ status is to use an independent appraiser to conduct the 409A valuation.

Beyond that, whatever appraiser you commission for the task must use a valuation methodology deemed acceptable by the IRS.

That will usually mean one of three approaches:

• Market approach: Under this technique, FMV is estimated by comparing the company in question to other similar publicly traded entities and/or based on the figures associated with recent mergers and acquisitions activity in that sector. This can often be the best approach for early-stage startups who may not be able to point to a profit-making history and so cannot yet predict future financial performance with sufficient authority.
• Income approach: When companies can point to a track record on revenue and cash flow, then the income approach can become a logical fit. With this method, the independent appraiser assesses FMV based on expected future cash flows, with relevant risk factors also considered.
• Asset approach: For the earliest of startups, i.e., companies that have not raised a significant amount of money or have not yet generated any revenue, opting for an asset approach may be the preferred course of action. With this method, FMV is estimated based solely on the value of the company’s net assets.

Where a company has multiple classes of stock, e.g., common and preferred, this can complicate the process of determining the FMV as each will need to be determined separately. In that scenario, appraisers will often use the option-pricing model (OPM) to generate an accurate value for each stock class. The OPM allows for the factoring in of the various terms and rights associated with each stock type when finalizing the respective FMVs. For example, holders of preferred shares may have more protection than common stockholders in the event of certain downside scenarios. Using the OPM enables appraisers to allow for such factors when determining values.

When do companies need to get a 409A valuation?

As stated above, companies are bound by law to receive a 409A valuation before granting stock options or other forms of equity. Once the FMV has been established, it must be updated at least once every 12 months, with a view towards ensuring that the valuation attached to stock continues to be a reliable estimate of the true value over time. In addition, companies are required to update the valuation at any time in the event of a material change in circumstances. Such a change might be triggered by the following:

• A new funding round: Securing an injection of capital from outside investors can impact directly on the value of company stock.
• Milestone events: A successful product launch or achievement of some other noteworthy milestone can impact positively on the value of stock. In the same vein, missing a deadline or a poorly received launch might drag down the company’s value. Whether positive or negative, this kind of movement will necessitate a fresh valuation.
• Major transactions: A major acquisition, a sell-off, a merger, preparing for an Initial Public Offering (IPO) – these all represent major transactions and as such should be expected to have a strong bearing on the valuation of the company. That being the case, the IRS expects that if any such movement progresses to the point where it becomes more ‘probable’ than ‘possible’, a new 409A valuation should be assessed.

The key take-home point for companies to understand is that having an up-to-date 409A valuation is required if your equity compensation practices are going to be deemed compliant with tax law.

Thoroughly documenting the valuation process is also important, as this will form part of your defense in the event of the IRS wanting to see evidence that you are following Section 409A requirements.

What next?

Do you want to know more about managing equity and Section 409A valuations? Reach out to J.P. Morgan Workplace Solutions today and see how we can help.