Startups are not cash rich, but employee salary expense is something that needs to be incurred every month. Most of the startup firms in order to circumvent this expense and at the same time reward their employees give them stock options and stock appreciation rights (SARs), these two common forms of incentive compensation for private companies are potentially within the scope of Section 409A code.
The IRS created this code after the dot com bubble and the perceived abuse of deferred compensation arrangements by the tech companies who were undervaluing stock options for tax benefits. So the IRS wrote the 409A Valuations code that requires an independent appraiser to value the common stock prior to issuing stock options.
409A valuations are performed to assist companies with setting the strike price for ESOP’s, which needs to be at or above fair market value. And the most common question surrounding this is: “Do I really need a valuation?”
Under 409A, stock options that have an exercise price less than the Fair Market Value of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with huge penalties.
The risk of noncompliance is that the option recipient will have to pay back taxes and a 20% penalty on the gain. The penalty is on the participant and not on the company.
The fair market value must be determined using “reasonable application of a reasonable valuation method.” A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, etc.). In most cases, companies choose to hire outside appraisal firms to meet this requirement.
Private company common stock virtually always has value; therefore, obtaining a defensible appraisal is an important step in potentially saving you from unnecessary IRS challenges and saving your employees from unexpected tax and penalties.
The valuation needs to be updated at least every 12 months or more frequently if significant changes occur in the business between grant dates. The events that materially affect the value of the company that require the management to get a 409A valuation done are as follows:
• Investment: Any new investment in the company on new terms is certainly
a material event.
• M&A activity: Your Company bought another company.
• More than 12 months have elapsed since the last 409A valuation.
If a company fails to comply with 409A, its employees will be personally liable for immediate taxation – plus a 20% penalty tax, and potential interest payments.
In a nut shell 409A can be considered a necessary evil.