For growing businesses issuing equity or granting options, there is a need for the entrepreneur to understand 409A and its impact on the business. This FAQ article addresses many of the relevant questions that may be raised by the entrepreneur or members of its Board of Directors.
The Importance of 409A for Growing Companies:
Frequently Asked Questions about 409A Valuations for Equity Awards
by Edmund Emerson III, Partner, Morris, Manning & Martin Employee Benefits Group
For growing businesses issuing equity or granting options, there is a need for the entrepreneur to understand 409A and its impact on the business. The following FAQ addresses many of the relevant questions that may be raised by the entrepreneur or members of its Board of Directors. We hope you find it useful.
Management of private growing and start-up companies need to pay close attention to the necessity of a proper valuation under Section 409A of the Internal Revenue Code (“409A”) when issuing equity to employees. In particular, an understanding of 409A is critical to the proper granting of stock (or unit) options and stock (or unit) appreciation rights. The following FAQ highlights the importance of a proper 409A valuation and the appropriate methods to use when performing the valuation.
1. What is 409A?
409A is a section of the Internal Revenue Code regulating “nonqualified deferred compensation” (which is basically defined to mean a legally binding right to compensation for services that will be paid in a later year) and imposes severe tax penalties on the employee (or service provider) if violations occur. 409A is very broad in its application, covering nonqualified deferred compensation plans, employment agreements, severance arrangements, change in control payments, and any other arrangements that result in deferral of compensation.
2. Does 409A apply to equity compensation?
Yes, but incentive stock options (ISOs) and restricted stock are exempt from 409A. In addition, non-qualified stock options and stock appreciation rights can be structured to be exempt from 409A, provided that (i) the option or right is for the “common stock” of the company, and (ii) the exercise price is at least equal to the “fair market value” of the underlying stock on the grant date. If the exercise price is less than the fair market value, the option or appreciation right will be subject to 409A.
3. Why do I want to be exempt from 409A?
Most companies want their stock awards to be exempt from 409A to avoid 409A’s onerous restrictions on the payment of the awards and the additional 20% tax, plus interest, imposed on employees or service providers for 409A violations. 409A requires that the time and form of payment be determined at the time of grant and permits payment only upon a specified date or the occurrence of certain other permissible payment events (such as separation of service or a change in control (as defined by 409A)). 409A also prohibits the acceleration of payments and substantially limits the ability to further defer payments. Essentially, 409A takes away the employee’s discretion to determine when to exercise an award and the company’s ability to accelerate the payment of an award.
4. Why are proper valuations so important when issuing options and appreciation rights?
Getting the fair market value wrong can ultimately cost the recipient of the award an additional 20% tax, plus interest, on the taxable value of the award – this is in addition to any applicable federal and state taxes. More than likely the recipient will look to the company for restitution of these additional taxes.
An improper valuation can also lead to company withholding tax issues (including penalties and interest for the failure to withhold 409A taxes), potential exposure for board members, financial restatements for the company, and the delay or inability to obtain outside financing, sell the company, or go public down the road. Finally, most of the IRS’s enforcement efforts with respect to 409A have focused on discounted stock options due to improper valuations.
5. What is considered in a proper 409A valuation?
An acceptable 409A valuation will determine the fair market value of private company stock by the application of a reasonable valuation method based on the private company’s own facts and circumstances. This valuation method must take into consideration all available information material to the value of the company, including at least the following:
- Historical profits, cash flow and liabilities;
- The value of tangible and intangible assets;
- The net present value of future cash-flows;
- The market value of similar entities engaged in a substantially similar trade or business, the value of which can be readily determined through objective means (such as recent arm’s-length private transactions or trading prices on established markets);
- Control premiums or discounts for lack of marketability;
- Whether the valuation methodology is used for other purposes that have a material economic effect on the company, its stockholders or its creditors; and
- The likelihood of an IPO, financing or dissolution.
6. How long can I use the 409A valuation in valuing awards?
Generally, a valuation will be valid for 12 months from the valuation date, unless there is a material change in the value of the company following the valuation.
7. If there has been a significant business event relating to my company, should I obtain a 409A valuation before issuing stock options or other equity?
Generally the answer is yes. The nature of events that could have a material impact on the financial condition of the company may suggest that a 409A valuation would be appropriate.
8. Does 409A provide any guidance on what are acceptable valuation methods?
Yes, 409A does provide certain “safe harbor” valuation methods, including:
• Independent Appraisal. Valuations based on a professional independent appraisal as of a date not more than 12 months before the grant of the award will be deemed reasonable.
• Start-Up Company Valuation. For start-up companies (less than 10 years in business) with illiquid stock, a valuation will meet this safe harbor if it is made by a person with significant knowledge and experience or training in performing similar valuations, and is evidenced by a written report (for example, by the board of directors) that takes into account all relevant valuation factors of the company. The person (who can be an employee of the company) performing the valuation must have at least 5 years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry of the company.
By consistently using one of these “safe harbor” valuation methods, the valuation will be automatically presumed reasonable if ever challenged. This shifts the burden to the IRS to prove that the valuation or the valuation method used was grossly unreasonable.
9. Do I need to retain a third party appraiser to conduct a 409A valuation?
No, but it is the easiest and safest way to value a company for 409A compliance purposes.
10. Will members of my Board of Directors or venture capital investors require that I get a 409A valuation from an independent party?
Many outside Board members or venture investors sitting on the Boards of growing companies will require that an independent party be retained to provide a 409A valuation. Generally, these valuations can be made at a reasonable fee.
11. If I decide to retain a third party to conduct a 409A valuation, what are the general costs and how long does it usually take to complete the valuation?
There are a number of third party appraisers who can conduct 409A valuations. For an early stage company, the fee can be anywhere from $3,000-$10,000, based on certain elements of complexity with the company. In some cases, the valuation may be more expensive if there are complicating circumstances relating to the business or if the record keeping of the company is not in great shape. The normal turnaround time for a valuation appears to be about 3 or 4 weeks, depending on the state of the corporate financial records and documents of the company.
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