A Comprehensive Guide to 409A Valuations for Indian Founders Incorporating in the US

Startups incorporated in the US have little value initially and may not have the necessary funding until the operations are up and running. Hence, they may not have the resources to hire skilled employees. In this situation, generally, a startup compensates its employees by giving them company stock options or opting for an employee stock purchase program. And for this, a startup will need to get a 409A valuation done.

Indian founders incorporating in the US often use a 409A valuation to help them determine the current strike price for employee stock purchase programs that are to be granted to employees. These options must adhere to IRS guidelines and have a fair market value (FMV). Keep reading to learn more about the 409A valuation and the procedures involved.

Before we talk about the 409A valuation, let us understand business valuation – it is the internal process of determining the economic value of a business, giving owners an objective estimate of the value of their company.

On the other hand, a 409A valuation is used by Indian founders incorporating in the US to find the fair market value (FMV) of the company. Typically, a third-party valuation firm, not the owner or the business, sets this value. The IRS-regulated 409A ensures that the options represent the company’s actual value by determining the strike price for the common shares that are usually granted to advisors, employees, and others.

The IRS needs the 409A valuation for the businesses so that these companies can easily maintain their safe harbor status. The business valuation performed for the startup during the fundraising phase or when the owner wants to determine the startup’s value is typically but not always different from this valuation. The IRS will generally assume that the valuation was conducted by an unrelated or independent entity, which creates a safe harbor, meaning that it is presumed to be “reasonable” by the IRS, but for a few exceptions.

Startups that violate Section 409A may later incur penalties, which include a 20% tax and interest payments, for their failure to comply. Future investors might also be reluctant to provide funding to a business that faces numerous tax risks and indemnities owing to violations of tax laws. This is why startups need to hire experienced 409A valuation providers to complete the company’s 409A valuation.

Getting a 409A valuation enables Indian founders incorporating in the US to adhere to all tax regulations of the US and prevent IRS audit sessions, which can result in legal concerns and tax issues and even interfere with the business operations if problems arise. Additionally, it would be quite expensive for a startup to hire advisors or attorneys to defend its business during litigation.

Moreover, the employees in the firm would suffer most in these situations owing to their immediate tax problems. It’s important to bear in mind that an employee stock purchase program acts as an incentive for employees and must not subject them to IRS fines or penalties.

The 409A valuation would protect employees from any future tax disputes that can arise with the IRS. Additionally, it protects the founder and the startup from any legal or tax liabilities. For example, if a startup does not get the 409A valuation and still offers an employee stock purchase program, that would have allowed them to purchase 2,000 shares at $3 each.

In the future, the IRS may investigate this option granting price and evaluate the business via an audit that determines the actual stock price on the grant date to be $5 for a share. From then, the share price may have increased a further $5 when the audit of the IRS starts. And when employees, as a part of the employee stock purchase program, have vested their options, they would now need to do two things:

• Immediately clear the income tax on the difference between the current value ($10) and the incorrect strike price ($3), which is $7 per share for the 2,000 shares. Therefore, whether or not the employee has exercised the option, the total amount is $14,000. Additionally, if the employee falls within the 33% income tax level, they would have to pay $4,620 as income tax.
• They must also pay the fine, which is the equivalent of the 20% price difference. According to the example, we have 20% of $14,000. This implies that the employee would owe the IRS an additional $2,800 in penalties.

Furthermore, the IRS would add a penalty and increase the total bill of $7,420 to something higher. However, if the startup had completed the 409A valuation on time and used the actual value of the shares at that time ($5 per share),  the employee would be able to delay the tax payment until they exercise the option for employee stock purchase program.

According to the illustration, if the employee buys the shares when they are valued at $10. The tax owed by the employee would be based on $7 per year. And with the tax bracket of 33%, the total tax bill would be just $4,620 for $14,000.

Following are the conditions for Indian founders incorporating in the US to get a 409A valuation done:

• A startup needs a 409A valuation to determine the options’ strike price when going for its employee stock purchase program.
• Every calendar year (A 409A valuation is valid for 12 months from the date of valuation)
• During or after new fundraising rounds
• When the company goes public, people start to purchase and sell the shares of the company, which do not include the shares that were issued originally.

A 409A valuation is done so that the Indian founders incorporating in the US, can avoid any possible penalties for valuation by the IRS.

For example, a startup is looking to hire top-tier candidates who are seasoned experts with relevant experience. However, the startup lacks the resources needed to offer them reasonable salaries. In this instance, they offer employees stock purchase programs, which are referred to as nonqualified deferred compensation (NQDC) under Section 409A.

As discussed previously, Indian founders incorporating in the US must complete a 409A valuation if they intend to grant their employees options. This employee stock purchase program will be protected by safe harbor protection if a qualified appraiser carries out a proper 409A valuation. However, many startups choose to wait until after the Series A fundraising to evaluate their company.

Click here to read more about when to get a 409A valuation done.

Here are a few questions that Indian founders incorporating in the US must ask themselves and be prepared to answer while having the 409A valuation to navigate the factors influencing its valuation:

This is undoubtedly the most crucial question and the first one a startup should answer, keeping in mind the industry the startup operates in, the services it provides, the tangible and intangible assets it owns, the profit the business generates, etc.

According to the situation and the type of business, the evaluator can explain this more clearly. A startup may need to apply more than one method to get the accurate value for its employee stock purchase program.

The IRS would examine the evidence of the valuator’s components that are specific to the startup.

Along with the quantitative models, they would also want the data that was used, such as restricted stock studies. Therefore, a startup needs to save all these things when getting a 409A valuation done to prepare for an audit.

There are never two different values for a corporation. Therefore, a startup must ensure that the 409A valuation is accurate so that it can be applied in any situation when a value is required.

Click here to read more about important questions every startup founder needs to ask before the 409A valuation.

As the company grows and evolves, the FMV will also change; this change will be reflected as variance if you don’t get your current FMV evaluated. This process of updating the current value of your company is known as a ‘409A Refresh.’ Getting a 409A valuation is not something that is done only once; in fact, a startup should get one at least once a year.

A 409A valuation gives a 12-month safe harbor period to Indian founders incorporating in the US, during which they may grant option grants at the specified strike price, in accordance with IRC Section 409A. To make sure that the IRS considers the stock’s value as “fair,” you can have an impartial third party determine the FMV of a company’s common stock once every 12 months.

Startups should typically get a 409A Refresh every 12 months to maintain safe harbor to offer employee stock purchase programs at the strike price during that period.

In case of a new qualifying round of debt, equity financing, or a significant event that might affect the company’s valuation, the startup will need to get a 409A refresh before the end of the 12-month period.

Section 409A contains a framework for private companies to follow when valuing private stock. When the valuation is conducted by an unaffiliated or independent party, it establishes a safe harbor, meaning that it is presumed to be “reasonable” by the IRS—except for a few exceptions.

IRC 409A indicates that if a valuation qualifies for safe harbor, then you are largely protected in the case of an audit. If the IRS challenges the valuation, they must prove that your valuation was “grossly unreasonable” with facts, figures, and documents, which is challenging to do.

A third party completes the 409A value 99% of the time, which is always regarded as the ideal method. There are a few instances where if the illiquid company is less than 10 years old, an internal employee with the necessary accounting skills and who does the 409A valuations accurately can provide you with the safe harbor status.

If a startup does not have a safe harbor, and the IRS audits it to find out that the startup has issued an employee stock purchase program at the wrong price, some employees would be taxed instantly and bear an extra 20% penalty on the difference in value in adddition to fines.

There are three ways by which Indian founders incorporating in the US  can get a 409A valuation done. Remember that only one of the three methods provides the safe harbor status that protects the company from an IRS audit.

If a startup has sound knowledge about the 409A valuation, it can perform its own valuation. However, if the IRS intervenes, you will need to prove that the valuation done was accurate. And in such circumstances, it is unlikely that everything will work out well. As a result, the startup may have to deal with the consequences that follow.

The next method involves getting the valuation done using a software application. Yes, many software applications are available, but are they trustworthy? Let’s find out.

409A valuation service providers never use a specific method when valuing a corporation because each business has a unique set of resources, and depending on the case, one method or a combination of two is used.

However, the software would not be aware of the subtleties. So, when deciding to use software valuation tools, be aware of their limitations and potential effects on the share price as a whole.

The best option for Indian founders incorporating in the US is to use a 409A valuation provider and pay for a safe harbor-protected, low-risk method. With this, the IRS would typically accept the valuation, and the startup need not demonstrate to the IRS that the valuation is accurate.

Finding a skilled and highly experienced firm is necessary for this process; for example, trica equity delivers quick yet comprehensive 409A valuation services. We go one step beyond compliance with the IRS norms and act as an informative tool for auditors and investors.

Click here to read more about trica equity’s 409A valuation process

Simply because the lower the strike price, the lower the amount the employees can benefit from the employee stock purchase program, making the offer extremely lucrative. Additionally, this implies that the company gets a higher realization value when it succeeds.

However, some founders believe that a lower strike price might harm their company’s reputation with investors, but this is not always the case. Investors typically do not use the 409A to analyze the business before they agree to fund it since they are aware that the 409A valuations are used to determine the common stock prices.

Choosing a lower strike price for the employee stock purchase program can put the startup at risk of IRS audits and penalties;

• There is no safe harbor protection, and the startup must provide confirmation of the strike price it chooses to the IRS during the audit. As a result, the startup would not be able to respond to any audit inquiries and demonstrate that the value it has chosen is accurate.
• The startup and its employees who exercised the employee stock purchase program would be fined if the actual strike price turned out to be greater than what had been specified.
• The strike price is low because the valuator lacks the credentials and experience necessary to value the enterprise.
• The audit firms might put the startup on their blacklist, and word would go around to other local companies.
• Even if a competent valuator had conducted the previous valuations, the startup would still face challenges because of the low valuation.
• Investors may not even hear the plea to raise funds for the business.
• If the news gets out, the startup may also lose its credibility, and new talents wouldn’t join.

The general guidelines and time frame for the entire process are as follows:

• Prepare and give the evaluator the data. The majority of 409A valuation firms require the following to proceed:
  • Full set of financial statements
  • Past 409A reports
  • Up-to-date Cap Table
  • Any assets or liabilities that are not noted on the balance sheet, such as compliance requirements, product warranties,  pending lawsuits, etc.
  • Article of Incorporation
  • Copies of documents or agreements dealing with shareholder rights
  • Copies of partnering agreements, rev share agreements,  joint ventures, etc.
  • Term sheets
  • Financial projections of minimum 1 year (preferably for 5 years)
  • History of secondary transactions
  • Preferred stock purchase agreements
  • Term debt agreements or convertible note

• The valuation provider will then run the reports, which typically takes less than three weeks.
• Once the first draft is prepared, the startup will be asked to review it and make any comments if required.
• The valuation provider will make the revisions after hearing the comments. The revisions typically involve lowering the strike price, which is the price for exercising a stock option in an employee stock purchase program.
• Then the final report will be given (revisions may take anywhere from 1 to 10 days to complete).

There are many ways for Indian founders incorporating in the US to determine their startup’s value under the 409A valuation. However, three main strategies are widely used. These can be used individually or in combination with each other, and the strategy(s) for valuation can change as a company matures.

This approach is applied when a startup has recently raised equity funding presuming that the investors paid an FMV for the equity.

The market value approach business valuation is a process where a value is assigned to a business based on market forces in comparable situations; these can be either a prior transaction involving the same business, an ownership transfer transaction involving a similar (public/private) company, and/or a market quote of listed securities of an equivalent public company.

The other market-based approaches make use of financial information from publicly traded companies that are in the same industry and similar in terms of revenue, net income, EBITDA, etc.

In the income approach of business valuation, a business is valued at the present value of its future earnings or cash flows. These cash flows or future earnings are determined by projecting the business’s earnings and then adjusting them for changes in growth rates, taxes, cost structure, and others. This simple strategy is used for businesses with a good cash flow and enough revenue.

This 409A valuation strategy is the least popular and is typically used for extremely early-stage businesses that have not yet raised any funding or generated any revenue. Hence, the asset approach is used to only calculate the net asset value to find out the correct value for the business.

Employers will be subject to withholding taxes on the vested deferred compensation portion of employees’ earnings if the 409A valuation is found to be non-compliant with the Internal Revenue Code. If employees do not receive their deferred compensation on December 31, the IRS will consider it to be included in your taxable year of failure.

The 20% penalty and premium interest tax are not subject to withholding taxes. The IRS can tax and penalize each of the NQDC arrangements if they are all subject to 409A requirements and have an operational failure.

This category includes unwritten bonus programs, severance agreements, executive employment agreements, pay deferral plans, supplemental executive retirement plans, and payment deferral plans. If there are multiple sets, the failure of one set of NQDC stock options or Stock Appreciation Rights (SARs) does not imply that all the other NQDC stock options or SARs will also fail.

Executives, employees, contractors, and other businesses suffer consequences when stock options in an employee stock purchase program are improperly priced or fail to adhere to safe harbor criteria. Penalties include the following:

• Gross revenue for the current year includes deferred pay for both the current year and prior years.
• Interest that has accumulated is added to the taxable amount.
• The amount of the deferred compensation that should be included in gross income is subject to a federal penalty of 20%.
• A 409A breach may also lead to state-level sanctions, such as additional taxes and a 20% penalty.

Click here to read more about 409A valuation overview: penalties and compliance.

Overall, the 409A valuation’s main goal is to safeguard a startup from audits. In addition, it helps in protecting employees from any potential penalties for inaccurate valuations. For some founders, the 409A value for startups is still a novel concept. Since a startup will need a 409A valuation every year, it is best to choose a company that can be trusted (and with whom you can build a long-term relationship).

trica equity offers expert 409A valuation services to startups in the US in partnership with Aranca. Our valuations come with a safe harbor and take into account all the macroeconomic, industry-related, and firm-specific factors for arriving at an accurate value.

Schedule a demo with trica today to get assistance in 409A valuation for incorporating in the US.