July 29, 2016
What Business Leaders need to know about 409A Valuations?
Issuing equity as compensation is a relatively simple process, but due to regulation in the IRC Section 409A created by the American Jobs Creation Act of 2004, employers are not permitted to issue options with an exercise price they simply pick. This is because the US Government determined stock options are a form of deferred compensation and if they were to be issued “in the money” then they could even represent current compensation – which triggers a taxable event to employees upon grant. To avoid tax liability for employees at the time of an option grants, the strike price for the option must be at or above fair market value such that their grant has no intrinsic value at the time it is received.
Why Do I Need a 409A Valuation?
In the US, equity compensation plans require businesses to verify the targeted exercise price is accurate according to the Fair Market Value (FMV) of a business’s common stock as of the option grant date. According to the IRS Revenue Ruling 59-60, FMV constitutes, “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Conducting a valuation according to established standards helps ensure grants are done at FMV.
Can I Perform the Valuation Myself?
If a company would like to issue options or any other form of deferred compensation to its employees, the company should strongly consider consulting with an expert adviser who can provide a conservative, fair assessment. That stated, if a company has someone internal to the company with the requisite experience such that others would rely on that person for valuation advice, a company may conduct its own valuation. A company’s board could also consider adopting a consistent formula for establishing fair market value. Likely the least complicated option for boards and leadership is to engage a firm that conducts these valuations all the time. Such a firm would be most familiar with the latest case law and accepted practices for discounting. Because private companies have stock that is not available on an active market, a documented valuation of some sort is required to determine the FMV and ensure boards and leadership are doing their fiduciary duty. Going with an estimate or trying to “ballpark” the value is likely to result in a price that does not comply with IRS standards that govern the measurement of fair market value. Another option that has come up recently is to get a valuation from a software provider. This may be a low cost option, but it remains to be seen how financial and tax auditors will view valuations that don’t demonstrate the judgment and arms-length independence exercised by accredited valuation professionals. Company’s paying for these types of valuations may find that they conducted a compliance exercise only to fail to comply with the tax code.
What Happens if I Don’t Have a 409A Valuation?
The IRS takes the tax code, including 409A, seriously. Most case law includes other infractions that caused red flags, but 409A is compliance is then also audited. Severe penalties can be imposed by the IRS for undervaluing company stock or not having a 409A performed properly. A company issuing non-qualified stock options at a price below FMV will also cause a taxable event for employees. Overvaluing a company will result in employees receiving less income than they would have otherwise. Once a company is large enough that they engage independent auditors, those auditors are always focused on ensuring companies adhere to rule 409A and use the report as an input to ensure correct accounting for stock option expense. At a reasonable price the fair market value and the value per share of Common Stock can be determined by an experienced provider who has knowledge on how to deliver reports that satisfy all constituencies.
How Do I Select a Valuation Firm?
With hundreds (maybe thousands) of valuation firms in the country, how should a company go about selecting an advisor? According to the IRS, a firm should have significant experience, which is defined as at least five years of relevant experience in business valuations – ask how long the firm has been conducting these types of valuations. The American Institute of Certified Public Accountants (AICPA) Practice AID suggests companies choose a valuation specialist with professional certifications (e.g., ABV, CPA, ASA, or CVA) – ask who within the firm carries these designations. The valuation firm’s reputation should also be taken into account.
In selecting a 409a provider, companies should do the following:
1. Ask the provider for their experience having a 409a report audited. New entrants with no audit experience could lead to you repricing your options after issuance – a significant pain point
2. Ask if the provider has experience working with clients in a particular industry, although quantity is not directly correlated with experience.
3. Ask for a sample report.