Venture-backed companies likely have valuation concerns regarding equity incentives granted to founders and employees as it relates to Section 409A of the Internal Revenue Code. 409A valuations are most commonly performed to assist companies with setting the strike price for their employee stock options, which needs to be at or above fair market value.
How do I know when I need a Valuation?
If you answer yes to any of these questions, it’s time for a valuation:
- Do you plan to issue stock options to employees and/or investors?
- Has it been 12 months since your last 409A?
- Have you recently raised a new round of funding?
- Has your company had any significant events impacting the value of its stock?
But do I really need a valuation?
Unlike for public companies, fair market value of a private company's stock is not readily available by looking through stock tickers. Accordingly, the IRS regulations dictate that “fair market value may be determined through the reasonable application of a reasonable valuation method.” They go one to state that if a method is applied reasonably and consistently, such valuations will be presumed to represent fair market value. A reliable independent appraisal is required to determine reasonable fair market value, which can include factors like secondary market transactions, founder stock redemptions, market value of comparable businesses (both public and private), etc. The consequences for failing to comply with section 409A make it critical to properly evaluate your company's fair market value.
Fair market value.
IRC Section 409A requires that stock options be issued with a strike price at or above the fair market value of the underlying stock. A 409A valuation is used to determine the fair market value so that the company can determine the exercise price of future options that will be granted.
Options granted with a strike price below fair market value of the underlying stock are considered deferred compensation and, if not previously recognized, are subject to two penalties to be paid by the employee:
- Interest in the amount of the federal underpayment rate plus one percent.
- An additional 20 percent income tax on top of the employee's regular federal tax obligation.
Bottom line: If your company fails to comply with the 409A rules, your employees will be personally liable for immediate taxation – plus a 20 percent penalty tax, and potential interest payments.
What else do l need to consider?
- 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.
- The valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (such as new rounds of financing).
Remember the IRS can look back 3 years, 6 years if there is a “substantial under reporting of income”. They are also known to use 20/20 hindsight.