What is a 409A valuation, and where do 409A rules come from?
I just want to issue some stocks/options/RSUs/etc.
Some time ago, executives at Enron figured out a loophole to grant themselves HUGE stock-based compensation. When the company went bankrupt, they accelerated their positions and became senior to debt holders, jumping the payout line. To prevent similar future abuses, the government, as part of the JOBS act, enacted section 409A regulating non-cash compensation.
If you’re a history junkie (like us), go down the rabbit hole and learn more about section 409a of the internal revenue code. If you just want to understand (tactically) why your lawyer / investor / board member told you to get a 409A valuation, read on:
Why am I required to do a 409A valuation? Do I actually need one? Can’t I just use a rule of thumb?
It depends how you define “need”.
The common stock of publicly traded companies -- even with analyst coverage, audited financial statements, and a large number of market participants -- is still subject to constant change. It would be infinitely more difficult to determine the exact value of a common share of a private company at every single point in time without undue burden. Given this practical issue, the IRS provides certain “safe harbor” methodologies for estimating the Fair Market Value of the common shares:
- Independent Appraisal Presumption: This is the most common method used by companies to comply with 409a rules. A valuation is prepared by a qualified independent appraiser, whose compensation must be fixed and not dependent on the result of the appraisal. The valuation is presumed to be reasonable if it values the stock no earlier than 12 months prior to the applicable stock option grant date, and if there have been no material changes since the valuation date. Under this approach, and assuming all requirements are met, the burden of proof is on the IRS to show that the valuation was "grossly unreasonable." Otherwise the valuation is presumed to be valid.
- Illiquid Startup Presumption: In some cases, instead of engaging an external, qualified, independent appraiser, a company may choose to perform the valuation in-house if all of the following are true:
- The company is private and less than 10 years old.
- The company is not anticipating a sale, IPO or change of control within the next 12 months.
- The stock is not subject to call or put rights.
- The person performing the valuation has significant knowledge and experience or training in performing similar valuations.
- Binding Formula Presumptions: Technically speaking, you may also value your stock by using a single formula that is marked to a tangible benchmark, such as Sales, EBITDA, or Net Income, applicable across all binding agreements (buy-sell agreement, grant of stock or options, loan conversions into stock, etc). However, this creates a number of restrictive conditions -- e.g. no stock may be transferred other than through operation of the buy-sell or similar arrangement to which the formula price applies -- and consequently few companies select this option.
If you have used one of the “Safe harbor” methods mentioned above, your valuation is presumed to be valid, and the burden of proof is on the IRS to show that you are “grossly unreasonable”. If, however, the valuation approach is outside of the above noted 409a valuation “safe harbor” rules, then the burden of proof shifts to the taxpayer to show that the value is correct.
So while you can technically use a rule of thumb, you may need to do a lot of work and careful research to be sure you are following all of the guidelines of the IRC section 409a. You’ll likely save yourself a lot of headache by hiring an independent appraiser.
The team at Preferred Return can give you a 409A valuation at a cost starting at $1,000, and we can deliver a first draft report within 3-5 business days. If you want to talk more, just schedule a time and we'll give you a call shortly.
What happens if I don’t get a a 409A and just wing it?
There are consequences from two main parties that you need to be aware of:
Because, the Board of Directors is responsible for setting the strike price of the Options, it is likely that your employee stock option plan (“ESOP”) includes a clause that states
as specified by the Board of Directors . . . in order for it to comply with the requirements of Code Section 409A
But if the Board has not used the aforementioned 409a valuation “safe harbor” provisions, the burden of proof is on the recipient to show that the value is correct. If the IRS is not satisfied, harsh penalties can fall on the recipient which include but are not limited to an immediate tax on vesting, an additional tax of 20%, and penalty interest.
As your company grows, various lenders or investors will require audited financials. This means that you have to go an engage someone like a PwC, Deloitte, or one of the regional firms to render an opinion on your financial statement. (What you’re looking for is an unqualified opinion, which basically means that your books conform to the necessary guidance - GAAP or IFRS - and the books are fairly representing your company’s financial position). One of the items that that you will have to record on your books is the historical strike prices at which you have issued options and the relevant cost of the options as they are earned - all covered under ASC 718.
Your external auditors will then ask you to substantiate those values. If you are unable to do so, you may get a qualified financial audit, which has negative implications from lenders or investors (i.e. warrants may prematurely accelerate vesting, or debt covenants will kick in and you’ll owe money sooner than planned).
As you can see, “winging it” can end up being a very expensive proposition. We at Preferred Return have delivered over 4,000 409A valuations as independent appraisers, and would be glad to discuss how we can help your company if you care to schedule a time.
When do I need a 409A?
Essentially, any time you are doing anything with your common stock, you should be able to substantiate the Fair Market Value of it. (see above to learn how “Safe Harbor” lets you shift the burden of proof from you defending your numbers to the IRS having to prove you are “grossly unreasonable.”)
Examples of “doing anything with your common stock” would be:
Granting options to employees
Granting options to advisors
Employees exercising their options
Entering into a partnership agreement where you are issuing stock as part of it.
You get the idea.
Why would my 409A valuation be different than my pre-money-valuation or post-money-valuation?
409A Valuation is the valuation which provides Safe Harbor to comply with Section 409A of the Internal Revenue Code (IRC 409A). Whenever the IRS is involved, the definition at hand is that of Fair Market Value (“FMV”). Fair Market Value is defined as the amount at which property would change hands between a willing buyer and a willing seller, when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.
Pre-money / Post-money Valuation is a term used by investors, lawyers, and companies to negotiate the terms of a financing. The valuation disregards the legal and economical rights and preferences of the securities exchanges, and thus produces incorrect (and inflated) valuation results.
How early should I get a 409A report?
We'll have a longer article about this later, but in short, by the time you have raised $250K in funding and/or two full-time-equivalents have contributed value to the company for a period of 6-months is usually a good time to get your first 409A report.
How long is the 409A good for? Can I just get one report and be done with this?
The intent of section 409A is that the company is not exchanging value without the proper tax considerations. You can’t estimate the value of your stock every day (and even if you wanted to, you definitely shouldn’t). Once you get a 409A report, the report is good for a period of 1-year, or until a material event has occurred. A material event is any event which a reasonable person would expect to noticeably affect your stock price, such as a fundraising round. There’s a bit of grey area here, so shoot us a note to email@example.com to talk to one of our experts.
Does it matter if I’m giving stock or RSU vs Options?
As an employer, when you give your employees any compensation (e.g. payroll), both you and the employee pay taxes. Usually, your payroll provider takes care of these relevant taxes (we use JustWorks and they're great). However, if you compensate your employees and contractors with something that is not cash, the IRS requires you to figure out the cash-equivalent value of the consideration paid so any tax implications can be calculated.
For example, if you give your employee 10,000 shares of stock, you have to determine the cash-equivalent value (referred to as the “Fair Market Value” or “FMV” in IRS language) and have your employee pay taxes on the value received. Let’s say the FMV of your share is $1.00. Your employee will owe 10,000 * $1.00 * their tax rate.
However, there is a workaround: if you offer your employees the option to buy your shares at $1.00 when the underlying share is worth $1.00 (i.e. if you offer options with a Strike price equal to the FMV), then the IRS effectively says “you are not transferring anything of value today, so no one owes taxes at the time of grant”. If, however, you state that your shares are worth $0.2 when they are really worth $1.00, then your employee will be subject to penalties under Section 409A of the Internal Revenue Code, as they have received a form of compensation.
How long does it take and how much does it cost?
In short, it costs between $1K and $7K, and it takes between 4 business days or 2 weeks (it all depends on complexity).
How do you figure out the value of private stock?
As a full-service valuation services firm, we are capable of deploying a wide array of valuation methodologies. When considering which methodologies to use, we consider a number of factors including (but not limited to) the purpose of the work, the hierarchy of facts and circumstances present, and the nature of the asset, liability, or equity being considered.
Here are a few examples of valuation methodologies we use that are regularly referred to by the AICPA and the IRS:
- Guideline Public Comparable Companies
- Guideline Transaction Approach (M&A)
- Venture Guideline Financings (also known as the “Backsolve”)
Income Approach (Discounted Cash Flows)
- Gordon Growth Terminal Value
- Hybrid (“H”) Model Terminal Value
- Multi-Year Exit-based model
- Single-Year Exit-based model
- Real Option Pricing
- Probability-Weighted Expected Return Method (“PWERM”)
- Normalized Earnings
- Asset Accumulation
- Replacement Cost New
As an additional consideration, when assessing methodologies to allocate the value to the various equity and debt holders of a private company, we consider the:
- Current Value Method
- Black-Scholes Option Pricing Model
- Probability-Weighted Expected Return Method
Specifically for private companies, we also consider potential Discount for Lack of Marketability (“DLOM”) by consulting the IRS’ Discount for Lack of Marketability Job Aid for IRS Valuation Professionals, which includes and is not limited to:
- Synthetic Put Option Analysis
- Empirical Studies
What data do I need to provide to get a 409A?
While every valuation is unique, once you’ve decided to work with us, we’ll generally need the following three main categories of data:
- Most Recent Capitalization Table
- Articles of Incorporation
- Debt Agreements (if any)
- Most Recent Balance Sheet
- Trailing-Twelve-Month Income Statement (ending the same date as the balance sheet)
- Projections (if available)
- Marketing / Pitch Deck
- Management Bios
In the event that the Preferred Return Valuation Analyst requires additional files or clarifications, they will reach out to you to discuss next steps.
About Preferred Return
At Preferred Return we’ve provided more than 4,000 audit-defensible valuations to over 2,500 clients since 2011. Our team works with companies of all kinds, taking a tailored approach to ensure every detail is addressed through every chapter of growth. If there’s something that we can help you with, let’s talk.