Here's What You Need to Know about 409a Valuation
As an entrepreneur, you may want to pay employees in part with company equity. There is a procedure you'll need to go through in order to do this. The IRS requires private companies interested in offering equity to have a fair market value appraisal done. This type of appraisal is known as a 409a valuation.
Challenges in Growing a Young Company
One of the biggest struggles of growing a young company is attracting talent and paying employees. Companies need the capital they have to support healthy cash flow to keep their venture alive. They might not be able to offer enormous salaries, but they rely on employee talent.
Public Vs. Private Companies
Some companies raise capital by going public and selling shares. However, this can lead to a situation where control of the company is lost to the shareholders. Staying private keeps you in control of your company. You can't sell shares on the public market if you stay private. Yet you do have the option of offering equity in your privately held company. It's very common for startups to offer stock options as a form of deferred employee compensation. This might be the best option for you to attract top talent by offering stock options.
Your First 409a Valuation
While getting your first 409a valuation might seem complicated, the procedure is simple and repetitive after you've had it done once. The most important thing to remember is that meeting 409a requirements is important. If you fail to comply with the tax code when offering equity in your company, you could face some severe negative consequences. It's therefore important to do your research and get your 409a valuation right.
A 409a valuation consists of IRS guidelines a private company needs to follow when evaluating itself. This is done before the company begins issuing either shares or options. Business owners have the option of doing their own 409a valuation. They might also choose to hire a third party to do their business valuation for them.
Simply put, a 409a valuation is a fair market value appraisal of the common stock of a company. A valuation of stock that's publicly traded is simple. It simply involves looking at the prices the stock is trading at. On the other hand, a privately held company must be evaluated independently.
This type of valuation is regulated according to Section 409a of the Internal Revenue Code. This section was added to the tax code back in 2005. It was added in response to the Enron scandal. The goal was to ensure that company executives don't exploit the offering of equity.
Section 409a
Any business owner wanting to offer stock options should familiarize themselves with Section 409a. This section sets forth the requirement that deferrals and distributions are timed properly regarding "non-qualified deferred compensation". The section applies whenever "deferral of compensation" is used by a company.
Deferral of compensation refers to a situation where compensation is not payable until a future tax year. However, 409a valuation isn't necessary for all types of deferred compensation. As an example, deferred payment through pensions and 401(k) plans does not required a 409a valuation.
Determining If You Need a 409a Valuation
There are numerous situtations in which you might need to have a 409a valuation done:
Compensate Employees
The most common scenario is that you want to compensate employees with company stock. However, there might be other scenarios when this type of valuation is necessary.
Offer Equity to Investors
You might wish to offer equity in your company to investors. This is another scenario where a 409a valuation would be necessary. This type of business valuation may be necessary any time you seek to acquire labor or funds by offering equity.
Determine the Strike Price
A 409a valuation is important when you need to determine an appropriate strike price. The strike price is an important number when you are issuing stock options. The strike price determines the value of the stock options you offer. Undervaluing stock options creates problems for your company, your employees, and any shareholders.
Sell Intellectual Property
Your 409a valuation can be important in other situations. One additional situation where this valuation is important is when you are seeking to sell intellectual property. When any intellectual property is sold between two companies, a valuation of the company stock of the company is typically necessary .
Factors Involved In 409a Calculations
There are many factors and figures that go into 409a calculations. The valuation process is complex. That's why companies often choose to have a third party handle it. A valuation can never be completely precise. There is always some level of subjectivity that goes into a valuation. However, amounts like the net present value of discounted cash flows of a particular company are used in calculations. It's also important to note that the goal is to find the value of the common stock. The common stock refers just to the portion of the company you want to offer to employees.
Those performing a valuation can choose from one of three different methods.
The market method
Of all three methods, the market method is used most frequently. With this method, the appraiser looks at similar market valuations. The market method involves using the principle of competition. The philosophy behind the method is that buyers and sellers have already agreed on the price of similar businesses on the market. Therefore, the appropriate valuation for the company is determined by the market.
The income method
The appraiser will analyze future discounted cash flows with the income method. This method is generally considered to be the most objective. At the same time, calculating future discounted cash flows for young companies is very challenging. That's because it's difficult to predict a young company's future. While the income method may be used for well established companies, it is seldom used for startup ventures.
The asset method
With this method, the appraiser looks to the assets the company has. The valuation is determined by the company's assets. Usually, this method is most commonly chosen to perform a valuation of a capital-intensive company. This method is also often used to evaluate holding companies. However, most startups don't follow into either of these categories. Therefore, the asset method isn't used very frequently.
Importance of Having a 409a Valuation Done
It's a legal requirement to have a valuation done to offer stock options. Failing to comply with the law and properly valuate your startup will have negative consequences. The IRS can impose penalties on companies that fail to comply. That's not the only consequence of failing to comply.
Your employees could face negative consequences. Employees could be required to pay added taxes on the stock they've gotten from you as deferred compensation. This could create problems with your employees that might even lead them to leave your company.
One other severe problem of failing to comply is messing up a company acquisition. When you're in the process of selling your company, you'll have a lot of trouble if you face non-compliance penalties. Failing to comply leads to indemnities and tax risk. These are things that will scare potential buyers away from your company.
Timeframe For Having a 409a Valuation
You need to understand the timeframe requirements regarding 409a valuations. Unfortunately, simply having one valuation done is not enough. The first time you need to have a valuation done is before you start offering stock options. It's important to know that a 409a valuation is only good for one year. You will need to have another valuation done after a year has gone by.
Material events
There are other events that could mean you're required to have another valuation done. You're required to have a valuation done every time what's known as a "material event" takes place. A material event can be any situation impacting the stock price of the company in question.
It's important to be able to recognize a material event. If you run a young company, the most probable material event you'll experience is a qualified financing. When you have a qualified financing, you should also expect a sale of preferred equity, common shares, or debt to investors. However, there are many other possible material events. These can include events like business model pivots, divestitures, acquisitions, and more. You should also have a valuation done again before a merger or an IPO.
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Improving Your 409a Valuation With Safe Harbor Status
It's best to achieve what's known as "safe harbor" status with your valuation when possible. You should be able to qualify for safe harbor status fairly easily. You simply have to go through a few steps. When you have safe harbor status, the IRS is unlikely to find fault with your 409a valuation. This protects you from fees and added tax. With safe harbor status, the IRS must take your valuation as valid unless they can prove it to be "grossly unreasonable".
Safe harbor methods
The easiest way to achieve safe harbor status is by having a qualified, independent appraiser handle your valuation. Having an independent appraiser handle the task also frees you from having to do the valuation yourself. However, you'll of course have to pay an independent appraiser to do your 409a valuation for you.
There are two other options for achieving safe harbor status. However, these alternate methods of achieving safe harbor status are more complex and less frequently used:
You can achieve safe harbor status through what's known as the binding formulate presumption.
Companies can also achieve safe harbor status with the illiquid startup presumption.
To Sum Up,
At this point, you should have a good idea of how the 409a valuation process works. You should be able to get your valuation done so you can begin offering equity to partially compensate employees. This will set you on track to growing your company. It's exciting to be an entrepreneur with a growing company. However, it can also be complicated. You have a lot of responsibilities to your employees. You also have a lot of requirements to meet. Neglecting to meet requirements set forth by the IRS like getting 409a valuations done could threaten the continued prosperity of your company.
As a business owner, you know the importance of seizing opportunities that come up. You also know the frustrations of not being able to seize opportunities due to a lack of funds. Once you have a 409a valuation done, limitations regarding capital hopefully won't hold you back as much. That's because you'll be able to partially pay for labor costs with stock options.
Remember that you need to keep up with 409a valuations over time. Just having one valuation done isn't enough. Keep track of your 409a valuation needs to maximize the potential that offering equity provides to your growing company.