In the world of startups, it is not uncommon for early employees to be offered stock options. This is typically to compensate for the lower starting salary and for the high level of risk they are taking with the business. If the company succeeds, the option owner may experience a little, or large, windfall. However, if the options are not issued correctly the company and employee could incur severe tax penalties. Continue reading to discover 5 things to know about a 409A valuation.
Before diving into why you need a 409A valuation it might be good to understand what it is. Section 409A of the Internal Revenue Code (IRC) deals with non-qualified deferred compensation. This is defined as “compensation that workers earn in one year, but that is paid in a future year”. This is different than elective deferrals to qualified plans, such as a 401(k). Stock options fall under the non-qualified deferred compensation category. When a company issues an employee an option, the employee is being granted the right to buy stock in the company at some future date for some specified price (the “strike price”). When issuing the option, the strike price must be declared, and this is where trouble can arise. If the strike price is below the current value of the stock, tax penalties could be in order. A 409A valuation is a report that can be compiled by a professional or the startup founders that provides the value of the company’s common stock to avoid issuing options with an incorrect strike price.
The process may vary slightly for each company, but the following is a good guideline for the vast majority of cases.
Throughout the entire process it is suggested to keep meticulous records. Document dates of meetings and when documents are sent, who is involved in each step, and any issues that arose and how they were resolved.
Startups should complete their first 409A valuation prior to issuing stock to employees or anyone else. After that, treat the valuation like a physical and do it again each year. It will also need to be done after closing any new funding rounds.
The IRS doesn’t dictate who can conduct a 409A valuation. However, be cautious of having too much rope. While a founder or CFO could conduct their own valuation, it is not advisable unless the individuals have extensive experience. Even then, having a professional review the valuation is advised. One major issue with a self-conducted valuation is that no safe-harbor protection exists should the IRS come calling.
The better option, and one that does come with a safe-harbor, is to have a professional firm conduct the valuation.
Achieving a level of success with your business and then having to submit to an IRS audit is something most reasonable people want to avoid. Forgetting to conduct, or simply avoiding, a 409A valuation can cause serious trouble for the company and its employees. If the IRS conducts an audit and believes that the strike price of an option is lower than it should be the employee will have to pay taxes at once, even though the option hasn’t been exercised. In addition, the employee will also receive a 20% penalty tax with interest due on the portion of the tax payable in prior years.
It should be noted that if your company is already public a 409A valuation is not necessary. Since the stock is publicly traded the markets will determine the current value.
The American Institute of Certified Public Accountants (AICPA) lists the following as just a few of the various options:
Companies could also use the option pricing method (OPM) where both common and preferred stock are considered call options on the company’s enterprise value. The exercise price is then based on the preferred stock liquidation preferences. The OPM is more sensitive to volatility than the other mentioned methods.
If you need assistance with your 409A valuation, then get in touch. Crowdfund.co’s team of investment bankers evaluates each company on an individual basis to determine the appropriate valuation method.
 IRS. (n.d.). 409A Nonqualified Deferred Compensation Plans. Retrieved June 29, 2018, from https://www.irs.gov/retirement-plans/409a-nonqualified-deferred-compensation-plans