How to Avoid 409A Valuation Issues With the IRS

Companies offer stock options to employees to reward and motivate them to perform well. It helps attract and retain top talent for businesses.
The value of these shares has to be determined before companies can issue stock options to their employees. Hence, the need for a 409A valuation.

This article explores various 409A valuation methods along with crucial information required to complete the process.

What Is a 409A Valuation?

A 409A valuation is a fair market estimate of the value of a company’s shares.

Section 409A of the Internal Revenue Code states that  all private businesses that offer nonqualified deferred compensation, such as stock options, stock appreciation rights, qualified employer retirement plans, and other common employee grants, must calculate the value of this compensation.

A 409A valuation is a tool used by the IRS to ensure that the right amount of taxes are paid on all stock options and deferred compensation. It is vital to conduct 409A valuation properly to avoid issues with the IRS.

Consequences of Inaccurate Valuation Under Section 409A

Here are the potential consequences of an incorrect valuation under Internal Revenue Code Section 409A:

1. 1% premium underpayment penalty on top of an IRS tax underpayment penalties
2. 20% penalty for inaccurate valuation
3. State fees
4. Penalties for shareholders when the shares vest
5. Dent to your company’s reputation as you could attract negative press

Important Data Required for 409A Valuation

Companies are required to gather important information before a 409A valuation. Typically, this information includes company information, a rough estimate of liquidity events, financial statements, and major events since the last 409A valuation.

• Company Information

Ensure that the names of the CEOs, external audit firms, and legal counsel are mentioned.

• Comparisons With Comparable Companies

A small part of the 409A valuation process relies on parallels between your company and other comparable firms. Hence, during valuation, you are required to submit the names of at least five companies that, according to you, are comparable to yours. It is important to note that all the companies you list will also be part of all the subsequent 409A valuations.

If there is no company that fits the criteria, you can choose a few which are closest comparables.

• Fundraising Information

If your company has recently raised funds, you should add the most recent pitch deck, board presentation, and executive summary of the fundraising campaign during the 409A valuation.

• Estimation of Key Events

When you are gathering important information before a 409A valuation, you must have an idea about the timeline of a potential IPO and/or merger & acquisition events. You should also provide details on  similar noteworthy events that have taken place since the last 409A valuation.

• Financial Statements

Companies need to gather all the important financial statements before a 409A valuation process. The predicted revenue and EBITDA for the next year should be included as well. You will also need to submit the profit-loss statement for the last three years, cash balance, and debt projects.

For a hassle-free valuation process, you must plan well in advance and gather all the important data.

How to Get a Safe Harbor Valuation That Complies With IRS Section 409A Valuation?

Although any valuation method that adheres to the IRS general guidelines is eligible, a company can be evaluated by any of the three approaches mentioned below.

• Independent Valuation

The most common valuation method is to have an experienced, independent external appraiser conduct the valuation.

The third-party appraiser must be given complete access to conduct the evaluation and consider any information that is relevant to the value of the company’s common stock.

• Illiquid Startup Insider Valuation

An inside valuation is acceptable if a company is not yet big enough to pay for the expenses of an independent valuation. A company must have the following aspects to qualify to use the illiquid startup insider valuation method:

1. Operating for not more than ten years
2. No publicly traded securities
3. No plans or expectations of getting acquired in the next three months
4. No plans to go public in the next six months

• Binding Formula Presumption

The 409A valuation done by this rule is based on the consistent use of a standard repurchase formula in the company’s stock transfers. Trends suggest that most early-stage startups refrain from using this method.

Different 409A Valuation Methods

A company can opt for a 409A valuation method based on different factors, including revenue generation and age of the company. You can select a 409A valuation method from the following.

• Market Approach

This is ideal for early-stage startups and non-profitable companies which cannot predict their financial performance in the long run. It takes into account that new investors are paying a fair market value (FMV) for their shares, while older investors receive preferred stocks.

• Asset Approach

This approach is typically used by companies that have consistently failed to generate revenue and companies that have not raised funds. The net asset value is used to determine the correct valuation here.

• Income Approach

The income approach is suitable for startups that have a positive cash flow and generate sufficient revenue. This approach primarily values a business at the present value of its cash flows and earnings in the future.

Final Thoughts

By now, we hope you have recognized that a 409A valuation is essential for your business, especially if you are planning to grant stock options or seek new investments. Although the IRS does not audit startups on a whim, they will waste little time slapping companies with hefty fines and penalties if you cannot justify your valuation.

On a side note, it is recommended that you consult a corporate lawyer if your company is planning to issue stock options as compensation to employees. In addition, your employees can also consult a lawyer to understand the nitty-gritty of these types of transactions.

If you are looking for professional assistance, trica can help you prepare for a 409A valuation. We offer a range of products, from end-to-end equity management to valuation services. Contact us today to book a demo and learn more.