Offering stock options to employees can be a win for both owners and workers — but chances are you’ll want a 409A valuation beforehand.
A 409A valuation protects the company in the event of an IRS audit and ensures your employees aren’t faced with an unfair tax burden come tax time. This guide to 409A valuations breaks down the topic in detail and covers why you can’t afford to skimp on IRS compliance.
What Is a 409A Valuation?
In its simplest form, a 409A valuation is an appraisal of the value of your company’s stock.
Any private company looking to offer stock options to employees must have a 409A valuation performed. If that’s you, a 409A valuation is in your future.
This evaluation also sets the ‘strike price’ used to exercise stock options. Stock options are just that — an option — to purchase company stock at a fixed price per share at some point in the future. The strike price is the agreed-upon price that an employee will pay for those shares.
Putting Strike Price, Stock Options, and Vesting Periods Into Context
Say your company decides to offer stock options to employees as an incentive. You may offer the option for an employee to buy 10,000 shares of company stock at $1 per share after, say, three years of employment.
Your 409A valuation determines that the strike price is reasonable and at current fair market value.
That $1 per share price? That’s the ‘strike price’. That three, four, or five year period before the stock options become available is the ‘vesting period’.
Of course, each company determines the terms of the vesting period.
Back to the employee: After three years, your employee exercises his stock options. He purchases 10,000 shares at $1 per share. However, your current stock price is $50 per share.
From an employee’s perspective, this is a huge win; after all, getting rich off stock options is the stuff of dreams!
In practical terms, your employee paid $10,000 for a $500,000 gain.
That’s a return that’s hard to beat.
What’s With “Fair Market Value”?
A 409A valuation determines the ‘Fair Market Value’ (FMV) of your company. The IRS needs to know that a company is not offering stock options below what the company stock is worth at that moment.
In practical terms, a 409A valuation sets the FMV of your company and guarantees that the strike price is fair.
That Seems…Difficult. How Do You Determine the Worth of Private Stock?
You’re not wrong.
Imagine a publicly traded company. The value of the stock is clear as day. It’s whatever the shares are going for on stock exchanges. The market is the appraiser, so to speak, that determines the value of a public company’s stock.
For startups, stock value is far more difficult to determine. Two primary methods exist: independent appraisal and illiquid start-up appraisal.
First Method: Independent Appraisal and Valuation
With this method, companies bring in professional outside firms to determine FMV.
These certified appraisers typically take a holistic look at the company and analyze the following and more:
- Financial data of the company (cash flow, assets, debts, operations, capitalization)
- The financial status of competing companies
- The overall financial health of the company
Of course, independent valuation services come at a cost. That said, a company that needs a 409A valuation must have one — the penalties for non-compliance are high.
Second Method: Illiquid Start-up Appraisal
Qualified companies may use valuations performed by a reasonably qualified individual. This person must have “significant experience” (at least five years’ relevant experience) with valuations, accounting, or a related field.
The following determines whether or not a company qualifies for this method of valuation:
- The company is less than ten years old
- The company does not “reasonably anticipate” an IPO within the next 180 days
- The company does not anticipate an acquisition within the next 90 days
- The company’s stock is not subject to put or call rights, barring the right of first refusal or related rights
What’s the Standard?
Outside appraisers perform the vast majority of startup 409A valuations. While it is possible to perform the valuation in-house, the risks of non-compliance are higher. The IRS recommends hiring qualified, independent appraisers; you don’t want to risk mistakes on something this important.
What Does a 409A Mean For Me?
A 409A valuation protects the company from conflicts with established tax law.
For business owners, a 409A valuation is your shield against potential IRS action. You’ll need this in the event of an IRS audit. A proper valuation will show the company’s stock valuation to be fair. In the end, there’s no real reason to not have a 409A valuation performed; it’s only risk and no reward.
Now, 409A non-compliance can place a significant tax burden on your employees (more on that below).
What Does a 409A Mean For My Employees?
This is where the 409A valuation really shines.
Take a simple example:
Imagine an employee considers his stock options. Assume either no 409A valuation is on the books, or it lists an undervalued strike price.
The employee takes stock options for 10 shares at $1 per share. However, the value of the shares has increased to $10 per share.
If the IRS performs a 409A audit, the employee must immediately (yes, immediately) pay income tax on the difference between the strike price and the company’s current share value.
In our example, our employee now owes tax on the difference between the company’s current FMV and the original (incorrect) strike price. The IRS considers this to be ordinary income, even if the vested stock option is not exercised.
Our unfortunate fellow must pay income tax on the difference between $100 (current FMV at $10 per share) and the incorrect strike price ($1 per share): a taxable amount of $90. That $90 is ordinary income and taxed as such.
That’s right — without a 409A valuation, your employees owe income tax in the same year as the audit.
On top of that, our employee will enjoy a penalty of 20% of the price difference of the stock options. They will also owe IRS underpayment fees, non-payment penalties, and possibly state tax fees and additional penalties.
Is It Really That Bad?
Yes.
It’s not an overstatement to say that the penalties for 409A non-compliance are heinous for your employees. Now, in our example, the taxes on $90 worth of income are not going to break the bank! But when you use real numbers, the tax bill goes up astronomically.
On the other hand, a properly performed 409A valuation allows employees to pay tax in the year they exercise their stock options. Thus, 409A valuations enable employees to defer their tax bill until the time they actually benefit from their options.
Do I Need a 409A Valuation? How Often?
If you’re running a private business looking to issue stock options to employees, you’ll need a 409A valuation.
According to the IRS, a 409A expires after 12 months or after a major change to the company. The IRS maintains that an event that materially affects the value of your company renders your current 409A obsolete.
Bear in mind, what constitutes a material change is rather unclear. It is safe to assume that any of the following is probably grounds for a new 409A valuation:
- Acquisition of another company
- A significant change in the operations of your company (unexpected new products or opportunities)
- A significant new source of external investment
If you’re looking for a rule of thumb to follow, it’s this: opt for a new 409A regularly or after any major or unexpected business development. You will also want to get a new 409A before any new rounds of funding.
How Do I Get a 409A Valuation? How Do I Choose a Good Appraiser?
An independent 409A appraiser is invaluable. Options abound, but if you’re a startup, you’ll want to pick a firm with an established history and solid reputation. The better the firm, the more solid your 409A will be.
It is highly recommended to opt for a firm that specializes in startups and small businesses. Given how difficult it can be to determine “fair market value” for startups, you’ll want an appraiser experienced in the field.
Costs vary between different appraisers and firms. Suffice it to say that paying for a comprehensive, holistic, and accurate 409A valuation is worth it!
Schedule a free consultation with Founder’s CPA today!
What’s This “Good Faith” Concept? And “Safe Harbor”?
“Good faith” comes into play in the event of an IRS audit. A reasonable and valid 409A is one that follows certain valuation guidelines:
- Takes into consideration the market value of similar companies
- Analyzes the company’s combined total asset value
- Examines the value of future cash flow and income
So long as your 409A valuation appraiser is a certified professional, there’s likely nothing to worry about. Companies that opt for in-house valuations run a much greater risk of scrutiny by the IRS. If the valuation follows the above guidelines set forth by the IRS, your valuation is valid under the “good faith” doctrine.
Safe Harbor
“Safe harbor” is a term that refers to a state of protection against audits.
If your company has safe harbor, the IRS must acknowledge the validity of your 409A valuation. Likewise, the IRS must prove that your valuation is “grossly unreasonable” — not an easy task!
Acquiring Safe Harbor
It is not difficult to acquire safe harbor. In fact, it’s guaranteed if you follow the aforementioned methods of 409A valuation.
IRC 409A lists three mechanisms for achieving safe harbor:
- Independent appraisal
- Illiquid start-up appraisal
- Non-lapse restriction method
In practical terms, get your 409A valuation from an independent appraiser and you’re covered.
Any Tips for Avoiding Audits or Penalties?
Absolutely — go get your 409A valuation before you issue any stock options.
That’s it. Simple, really.
Think of your 409A as an insurance policy against a potential audit. It protects you, your company, and your employees. Anytime you think of the expense associated with a 409A valuation, consider the impact of not doing it. The penalties for non-compliance are borne mostly by your employees, after all.
409A Valuations for Startups and Small Businesses: Get It Done!
The benefits of a 409A valuation are impressive: protection from audits, tax advantages (and protection) for employees, and compliance with tax law. If your startup or small business is considering issuing stock options to employees, give Founder’s CPA a quick call.
A free consultation regarding the importance of 409A valuations may prove invaluable down the road.
