Let’s consider a situation and think that you are the founder of a startup. Say it company X. Your company is growing rapidly and time has come when you are planning to offer stock options to employees. Do you know what should be the appropriate exercise price or strike price of stock options? For this you need a 409A valuation. Never heard about a 409A valuation? Nothing to worry. Here we will try to understand some important facts about a 409A valuation.
What Is a 409A Valuation?
A 409A valuation is an assessment of the fair market value of company’s common stock. You can check stock price of any publicly traded company easily at any given time. However you need an independent appraisal done for a privately held company to find out the worth of your company.
The 409A or IRS Section 409A was added as part of the American Jobs Creation Act of 2004 and it states:
“Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as non-qualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.”
Stock options are considered non-qualified deferred compensation and gives employees the option to buy common shares of your company in the future at a price (the strike price) that is determined today. A 409A valuation will figure out an “exercise price or strike price” that must be at or above fair market value.
When do you need a 409A valuation?
There are scenarios when you must get a 409A valuation done as below:
- At the time a privately held company closes a new funding round.
- At the time of any M&A activities involved.
- At every 12 months
What are the triggers for a 409A valuation?
Below are the triggers, when you must go for a 409A valuation:
- In case a company has identified a consistent revenue source.
- If a company has raised > US$500K through investors.
- If a company has raised money through a convertible security or issued preferred stocks
- If a company reasonably anticipates an IPO within the next 180 days or M&A activities in the next 90 days
- In case of secondary transactions happened in the company.
- In case a company has more than US$100K in assets
What are the factors influence 409A valuation?
A 409A is an appraisal. To determine fair market value firms generally go with one of the following approaches:
- Market approach: How much your business worth as compare to closely held business?
- Income approach: How much income a business can generate in future?
- Asset approach: An analysis of a company’s tangible as well as intangible assets.
What are the various ways to get a 409A valuation?
There are 3 options available to get a 409A valuation report as below:
- By yourself: This option has most riskiness among all due to no “safe harbor” protection in the IRS. It means that you will be 100% accountable for the valuation, although you can save money but there are more chances to make mistakes, unless you have the required education and expertise to do 409A. It is always better to leave it to the professionals.
- By Software: This is also a risky option. Only some startups are allow to do valuation by software which are in early stage. (i.e. The company has not generated revenue consistently, company has not raised more than US$500K, company does not have an IPO in the next 180 days or an acquisition in the next 90 days, company’s assets base is not very large, typically <US$100K).
- By an independent firm: To get safe harbor companies advised to hire an independent firm for 409A valuation. By doing this company will pass the burden of proof on the IRS. So what does being “independent” actually mean? According to IRS an independent valuator to qualify for safe harbor is defined as:
“Valuators will employ independent and objective judgment in reaching conclusions and will decide all matters on their merits, free from bias, advocacy, and conflicts of interest”
Do you really need a 409A valuation?
To keep it simple, a 409A valuation is necessary as required by law. Companies need a 409A valuation report to ensure that the company is in compliance. There can be terrible consequences for non-compliance companies. Undervaluing stock options can result into serious penalties and lost compensation.
Conclusion – Consequences of non-compliance 409A valuation?
A business owner can face some really bad time in case of not calculating stock options price correctly. As a general rule, all stock option grants need to have a strike price greater than or equal to the fair market value of the company’s common stock on the grant date.
An options holder found to be in violation of 409A will have to face below consequences:
- Pay taxes plus a 20% federal penalty
- Any applicable state penalties
- An IRS tax underpayment penalty.
- Any interest on unpaid taxes.
In addition to the above said, it will affect your funding and businesses partners for sure. At the same time, in case of overestimation of the fair market value, company’s employees will receive lesser income than they otherwise would have.
To understand the above said, let’s try to understand the situation with a simple example:
Let’s say you grant Mr X (your newly hired operational manager) 1,000 incentive stock options at US$2 / share with vesting over 5 years. You just literally “guessed” when you set the strike price at US$2.
2 years down the line the IRS chooses your company for an audit. According to IRS, your company’s valuation should have been US$3 / share and believe that your company is worth US$30 / share currently.
What are Mr X’s costs in this situation?
It turns out that they are really nasty:
Immediate ordinary income tax. Mr X will be taxed this year on the spread between the company’s current fair market value (US$30 / share) and the incorrect grant fair market value at ordinary income rates (say 40%): 40% * (US$30-US$2) * 1,000 = US$11,200.
20% Penalty. Mr X will be liable for an additional 20% penalty on the spread: 20% * (US$30-US$2) * 1,000 = US$5,600
Interest. Mr X will have to pay interest on the underpayment of calculations. This calculation might be too technical for this article but it could easily add another meaningful payment.
Payment owed as security vests. It will be worse. Mr X will be liable to this payment as his shares vest, not when he actually sells his shares. If he wouldn’t find a suitable buyer, he will have a huge tax bill on a paper even without actually liquidate the shares in real.
Problems for the company as a whole. Mr X alone can be liable for US$170,000+ in taxes but the company probably didn’t only grant shares to Mr X applying through this incorrect valuation, it may have granted shares to other employees as well. The impact in real could be 20x+ than what we have calculated in above said example.