What is a 409A valuation?
Business valuations are important events in a company’s life cycle, especially in its progress towards an Initial Public Offering (IPO). For well over the past decade, reports that value the equity of a company have been in high demand. There are several types of valuation reports that companies can obtain, including a so-called 409A valuation report. A “409A valuation” refers to Internal Revenue Code (IRC) Section 409A, which regulates the treatment of “nonqualified deferred compensation” for federal income tax purposes. 409A valuation reports are used by companies to support the value of their underlying equity and the resulting stock options related to that equity. Section 409A is especially relevant for companies that issue stock options, which many start-ups and smaller companies use to incentivize employees when cash flow is limited. A 409A valuation enables companies to set an appropriate strike price on stock options so the options fall outside the purview of section 409A. A 409A valuation is not necessary for companies who don’t grant stock options or any other type of deferred compensation, such as companies who only pay employees in cash. However, in practice, stock options are widely used, and as a result most companies need a reliable 409A valuation.
Individuals working in different professions have a distinct vernacular when talking about the valuation stemming from Section 409A. In practice, financial accountants and valuation specialists refer to this type of valuation as just a “4-O-9-A Valuation,” as you might expect. Tax specialists refer to the code section as “Section 4-O-9-Cap-A,” distinguishing the entire section 409A from the unrelated paragraph 409(a).
What makes a 409A valuation different?
A 409A valuation report is used to establish the underlying equity value of a company and is used primarily (A) to comply with the tax code when setting the strike price of an option to buy common stock and (B) to calculate compensation expense for financial reporting purposes. A 409A valuation often focuses on determining the fair value of the common stock; other types of valuation reports, such as those distributed by a company when seeking funding from outside investors, focus instead on preferred stock, which usually commands a higher price and higher valuation. An outside investor, such as a venture capitalist, desires the true value of a company to determine how much to invest and the resulting ownership percentage. Because of the differing purposes and uses of the valuation reports, a 409A valuation does not always use the same methodology as a valuation that might be used to support other equity purposes by outside investors.
Why do I need a 409A valuation?
Section 409A governs the treatment of nonqualified stock options and incentivizes companies to structure the options a certain way. Employee stock options often make up anywhere from 5 to 15% of the capitalization table1 (“cap table”). Any company routinely issuing stock options to employees should be motivated to comply with Section 409A and the authoritative guidance that updated and clarified it (Treasury Regulations under Section 1.409A [“Treas. Reg. Sec. 1.409A”] published in Internal Revenue Bulletin [IRB] 2007-19 as T.D. 9321). Two main issues arise when a company doesn’t have reliable and frequent 409A valuations performed: first, employees may pay extra taxes and penalties on the options; and second, the IPO process could be delayed by the SEC due to inaccurate and unsupportable financial data.
The Employee Tax Problem
First, this article is for informational purposes only, not for official tax advice purposes, and we recommend working with tax experts to confront the issues and determine how they may apply specifically to your business. However, we hope to help companies understand the issues at stake and the potential obstacles to avoid. The following paragraphs may help you identify and gain a working knowledge of some of these issues.
Section 409A deals with all nonqualified deferred compensation plans, which could include some stock options. Some types of deferred compensation are “qualified” and exempt from Section 409A, such as 401(k) plans, other retirement plans, 427 plans, and incentive stock options (ISOs).
While this may seem elementary, it may be helpful to briefly review employee stock options and the related vocabulary to better understand the Section 409A employee tax issue. A stock option allows an employee, also known as the option owner, to buy a share of a company’s stock for a predetermined price, called the strike price or exercise price. A service recipient (e.g. the company or employer) awards an option to a service provider (e.g. the employee) on the grant date, and the employee can generally use, or exercise, the option after the vesting period. The exercise date is when the employee exercises the options and purchases the shares at the strike price. At various points in the existence of an option, such option can be in-the-money, at-the-money, or out-of-the-money, depending on the market value of the stock relative to its strike price at any given time. If the strike price is less than the market value, then the option is said to be in-the-money, because if the employee exercises the option and the newly-acquired stock is immediately sold, the employee realizes a gain. An out-of-the-money option is the opposite—it is worthless at that point in time because an option owner would do better to purchase the stock in the open market at a lower price rather than exercise the option at a higher strike price. An option is at-the-money if the strike price is equal to the market value. For in-the-money options, the spread between the strike price and market price is called the bargain element.
An employee is normally taxed on the bargain element when she exercises a non-qualified option (NQ option). For example, suppose an employee has a vested NQ option with a strike price of $40, and she exercises the option when the market value of the stock is $50. The option is in-the-money, and the employee is taxed on the $10 bargain element as ordinary income. The cost basis of her stock is then $50, and any realized gain or loss from a change in price when she sells the stock is subject to treatment as a capital gain or loss. Often, an employee will immediately sell the newly acquired stock for the same price, in this case $50. Due to transaction costs, the employee may actually report a small short-term capital loss in addition to the $10 ordinary income from the bargain element. However, the key takeaway here is that an employee is not normally subject to income tax until the option is exercised.
Determining whether a stock option is exempt from Section 409A treatment hinges on whether the option is in-the-money at the grant date. To make this determination, a company must first know the fair value of its stock, and Section 409A defines “the fair market value of the stock …[as] a value determined by the reasonable application of a reasonable valuation method” (Treas. Reg. Sec. 1.409A-1(b)(5)(iv)(B)(1)). Stock options that are in-the-money on the grant date are immediately taxable to the employee as ordinary income—the amount taxed is the full difference between the strike price and the market value. The timing of taxation due to the issuance of “in-the-money” options is often determined sometime after the initial grant, usually when the grant is deemed to be in violation of Section 409A. The employee is taxed as of this determination date. This sudden taxation event can present the employee with what is known as a “wherewithal” problem, as the employee must use personal-source cash to pay taxes on non-cash and illiquid income. In addition, the employee is penalized with an extra 20% tax on that income, beyond their ordinary income marginal rate. For example, if an individual’s ordinary marginal federal and state tax rates is 40%, then she would pay a 40% tax plus the 20% penalty tax for a total effective tax rate of 60% on that income. Further, in subsequent years, the employee must also recognize into income any additional appreciation in the options (value increased since the prior year-end) until the options are exercised, forfeited or cancelled. And to throw salt in the wound, the employee must also pay interest on the tax underpayment for each tax year as well. Because this is all considered current income, the employer must account for withholdings on this gross income.
To avoid this unwelcome taxation surprise, Treas. Reg. Sec. 1.409A-1(b)(5)(iv)(B)(2) creates a presumption of reasonableness test for taxpayers. This test presumes that a valuation of an option will be accepted by the IRS and deemed reasonable if (1) such valuation is performed by an independent appraiser that meets certain requirements and (2) is performed no more than 12 months before the relevant transaction, such as the date of grant of a stock option. If such test is met, the valuation is presumed to be reasonable. If the IRS does not think the valuation is reasonable, the IRS “Commissioner may rebut such a presumption upon showing that either the valuation method or the application of such method was grossly unreasonable.” In simpler terms, failure by the taxpayer to meet this test will place the burden of proof on the taxpayer to defend the valuation; meeting the test transfers the burden to the IRS, requiring them to prove an unreasonable valuation. Note that the presumption of reasonableness is not a safe harbor rule. Simply meeting the requirements does not guarantee the IRS will accept the valuation as reasonable, but it does transfer the burden of proof to the IRS, which historically has proven to be a very valuable position to taxpayers in similar presumption test areas of the tax law.
While not legally required, companies should also have a 409A valuation done any time the company receives new funding, turns profitable, has a major growth acceleration, or experiences any event that would significantly impact its value. The most defensible timing of a valuation as it relates to stock options and Section 409A would be within a few days of stock options’ grant dates, though a valuation within the previous 12 months is the minimum standard to meet that element of the presumption of reasonableness test. If the IRS or SEC can successfully assert that a valuation or a strike price is grossly unreasonable due to the timing, quality, method, or lack of a valuation, a retrospective valuation will be required. People are subject to hindsight bias, and the retrospective valuation of a profitable and growing company could potentially lead to a higher option valuation for previously issued options than a reasonable contemporaneous valuation performed just prior to option grant. This hindsight valuation approach could potentially push an otherwise reasonably priced option into a tax controversy under Section 409A, which could result in additional and unforeseen taxation to employees owning the options. By having a 409A valuation done frequently, a company decreases the risk of the IRS taking issue with the strike prices of the stock options they award.
The GAAP Compliance Problem
Another problem stemming from poor or infrequent 409A valuations is commonly referred to as a “cheap stock” issue in financial reporting. Accounting Standards Codification (ASC) 718 is the GAAP standard regarding accounting for stock compensation. The SEC requires all publicly traded companies to have an independent financial statement audit that shows they conform to GAAP in their accounting.
When a company issues a stock option, the fair value of the options is estimated using an acceptable model, such as the commonly used Black-Scholes model. Note that the fair value of the option is not the strike price nor the market value of the company’s stock, but the value of the option itself. In many estimation models, including Black-Scholes, the value of the option is influenced by the strike price, the market value of the stock, the relationship between those two values, and the forecasted volatility of the stock price. The estimated value of the option is treated as compensation expense over the vesting period. For example, if the fair value of an option is estimated at $10 and the option vests at the end of 5 years, then the compensation expense associated with that option is $2 each year, or $.50 each quarter.
When preparing for an IPO, a company must present GAAP-compliant historical financial data to the SEC. If a company cannot provide the SEC with a reliable business valuation, the SEC may assert that the options granted in previous years were undervalued—that is, the value of the firm, and thus the value of the options, were greater than the previously reported value. Correcting this “error” would increase the stock option value and the related compensation expense over many periods, and net income would decrease for those periods. This discrepancy can delay the IPO process and prove costly to remedy. In practice, a poor valuation is usually identified and remedied during an independent audit. The so-called “Big Four” audit firms and most second-tier and regional audit firms routinely deal with this issue and will identify any valuation or compensation expense errors. Even though you will probably not begin SEC filings without having fixed the cheap stock issue (if any exists), the pre-IPO process can be delayed and drawn out, ultimately delaying your IPO.
As another practical note, the methodology used to complete a valuation for financial reporting purposes under ASC 718 and Section 409A are slightly different. A valuation may be reasonable for Section 409A purposes but materially misstated for financial reporting purposes. This stems from the difference in wording between the two sets of authoritative guidance. Section 409A, as mentioned earlier, explicitly states that a company may use a Section 409A valuation for any stock option granted within the subsequent 12 months to create a presumption of reasonableness, as long as the valuation method or its application is not “grossly unreasonable.” ASC 718, on the other hand, requires companies to “estimate the fair value at the grant date of the equity instruments” (emphasis added). This can be very different from the 12-month window allowed by Section 409A. Thus, some companies encountering cheap stock issues adjust the compensation expense for financial reporting purposes without adjusting the valuation for Section 409A purposes.
For more detailed information about the cheap stock issue, see our article, “Cheap Stock,” on this site.
409A valuations: what do companies do and what does it cost?
Depending on the stage of your company, you may have noticed that in today’s business environment, most companies are Section 409A compliant. Most companies are Section 409A compliant from inception because the founders have been advised on the importance of a Section 409A valuation. However, we’ll consider the three general categories that companies can fall into when considering how they support their reported stock option valuation: (1) those companies that don’t obtain a valuation study, (2) those who generate a valuation study internally, and (3) those who hire a valuation specialist (which includes most companies today).
No 409A valuation performed
Noncompliance with Section 409A was more common soon after the regulation first became effective in 2005, but over the past decade or so, most companies with growth prospects and their sights set on a potential acquisition or IPO have been 409A compliant, according to the CEO of a national valuations firm. At the latest, a company can postpone a 409A valuation until the time of the first stock option grant. Obtaining a first-time 409A valuation after the first stock option grant will likely result in tax issues with the IRS and a delayed and extended IPO timeline when working with external auditors or the SEC.
Do it yourself (DIY)
Performing your own 409A valuation is a real possibility, but most tax accountants, valuation firms, and others familiar with Section 409A do not recommend this approach. Companies other than start-ups still in their infancy rarely (if ever) perform their own 409A valuations in practice. Valuing your own company often does not produce an acceptable valuation from a third party’s perspective, and by doing so your company gives up the assertion of the presumption test upon challenge by the IRS. A DIY valuation, by definition, is not performed by an independent party. While founders and executives may be in the best position to perform an otherwise reliable and accurate valuation, the valuation itself will be viewed as biased and often discounted because it is not independent. Some additional practicalities and legal issues surrounding a DIY 409A valuation also make it unattractive to most companies.
For any valuation to be within support of the presumption test, the valuation must be performed by someone qualified to value a company. This person should have “significant experience [, which] generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates” (Treasury Regulation Section 1.409A-1(b)(5)(iv)(B)(2)(iii)). Even if someone within the firm is qualified, doing your own valuation requires many complex calculations, estimates, and assumptions, many of which may unintentionally incorporate unsupported biases. Treas. Reg. Sec. 409A suggests a few reasonable valuation methods, with the caveat that a valuation method is not reasonable if it “does not take into consideration …all available information material to the value of the corporation.”
One basic valuation method, called the Discounted Cash Flow (DCF) method, relies on forecasting future cash flows and discounting these cash flows to a present value. Generally, a company will go through several rounds of funding; when forecasting future cash flows, the company should consider, estimate, and probability-weight different scenarios of the timing and the amount of future funding. A company should also consider multiple exit scenarios, such as an acquisition or IPO, weight their relative probabilities of occurring, and apply those probabilities to the valuation method. An appropriate discount rate for each scenario should be estimated and may vary from scenario to scenario.
Another basic valuation method involves looking at the financial data and valuation of comps2 and adjusting for firm-specific differences to arrive at a fair value of the company. Yet another valuation method is valuing the identifiable tangible assets and intangible assets of a company, which can sometimes require a DCF-like approach for specific assets.
All methods for valuing a company should be combined and weighted according to a subjective judgment of their accuracy and applicability to the company.
As should be evident, the DIY method can require many complex models and modelling techniques that may not be available to smaller private companies. These models require subjective inputs and assumptions, as does any valuation model. However, regulators may discount the credibility of the valuation process if the subjective inputs are also aggregated and processed by those who also provide the inputs themselves—the credibility and reliability can be diminished without third party involvement.
However, for some start-up companies, the minimum threshold for a valuation is that it is reasonable, it is done in “good faith,” and its inputs and factors are written in a report. A DIY valuation may be acceptable for very small start-ups with little or no revenue, few employees, a simple capital structure, no venture capital funding, no prospect of an IPO for many years, etc. While in their infancy, many start-up companies unsure of their future existence will often make business decisions now to conserve cash flow and precious equity at the expense of future costs and reworking. The decision to utilize a DIY approach is most often a function of limited cashflow that is prioritized elsewhere in the business. To that end, there are some free and cheap technological tools available online that such a company can use, and each has its own policy on the types of companies that can use the tool for a 409A valuation. However, any company seriously considering an IPO at any time in the near future should recognize the limits of such a DIY approach. Doing your own valuation or using a free tool may temporarily satisfy a board of directors, but will most likely fail to pass the presumption of reasonableness test or to obtain eventual SEC approval for any active award during the years presented when filing for an IPO.
The cost of the DIY valuation may be minimal in terms of cash required for the valuation at the time of the relevant corporate event, but the potential cost to perform the service often increases when considering the long-term issues that arise if the valuation is not perfect or adequately defensible. Companies should consider the potential cost to employees due to excess taxes and fines, the cost of going to tax court to defend an IRS audit, the cost of delayed IPO funding, the cost to hire accountants and lawyers to respond to additional SEC comment letters when preparing an IPO, and the short-term opportunity cost of an executive’s time spent to perform the valuation. These costs can be staggering and frequently overtake the immediate cash savings from a DIY valuation.
Hiring a valuation specialist is primarily recommended by most experts as the only feasible alternative for companies anticipating a future IPO. Depending on the size and complexity of your business, these valuations can take anywhere from a week for the simplest valuation to a few months for companies close to an IPO. For small start-ups and other companies that may be limited on cash, the initial cost of a valuation by a specialist can be a major deterrent; however, the benefits often outweigh the costs if an IPO is on the horizon. Based on conversations with valuation professionals and those familiar with the issue, companies that hire valuation specialists rarely have the IRS rebut the presumption created by a properly crafted valuation, often have a smoother process with the SEC as they prepare for an IPO, and frequently have better employee relationships.
A 409A valuation is relatively cheap when compared to the cost of an independent audit, attorney fees to prepare an S-1, and other costs to operate a business and take it public. The simplest of companies can have a reliable 409A valuation done for as little as $2,000, while complex companies nearing an IPO can expect to pay upwards of $20,000 for a reliable, quality, and accurate 409A valuation. Across the board, the average cost of a 409A valuation is in the $3,500 – $4,000 range, according to the CEO of a national valuations firm. Of course, these costs will vary depending on the industry, geographic location, growth stage, and general risk of your company, in addition to the overall economic climate at the time of valuation. There are likely many local, regional, and national valuation firms that operate near your place of business, and it would be wise to get quotes from multiple firms to get the most competitive price for a high-quality valuation.
Valuation firms often have proprietary models and technological tools they have developed to accurately forecast financial data, calculate the cost of capital, and perform other elements of a high-quality valuation. 409A valuations performed by specialized firms are often the most reliable and accurate 409A valuations available, but the integrity of the valuation depends on the information they receive from your company. Be sure to bring as much information and documentation as you can to the initial meeting. Examples of information the specialist may request include
- transactional data;
- historical records of funding, including amounts and timing;
- details of capital structure;
- realistic expectations for exit opportunities;
- historical and expected growth of customer base, revenue, costs, profit, and cash flow;
- cash collection information for sales made on credit;
- recent product or service innovation and development;
- proof of concept for future product and service offerings;
- other details and information that would affect the valuation of your company.
This is not an exhaustive list by any means, and the specialist will likely ask for additional information based on your industry, circumstance, growth stage, venture capital and private equity history, and future plans. For added support and justification in case of an audit, be sure to keep contemporaneous records.
In addition to the high-quality valuation these firms offer, perhaps the best reason to hire valuation specialists is for peace of mind and insurance. Most reputable firms will defend their valuation and valuation methodology. Of course, the models and methodologies are only as good as the data inputs, which come from management. While the firms may not defend invalid or inaccurate data received from management, most will defend the method and assumptions they make, and they will often assume the associated liability up to the price paid for the valuation.
409A valuations: what do companies do and what does it cost?
If you’re a stock-option-issuing private company looking to go public in the future, you will perform 409A valuations—it’s simply one of the costs of doing business, just like an audit or marketing expenses. History provides us with some examples of what can happen when a company tries to avoid such a cost.
Consider the real-life example of a small tech company that was in the process of being acquired by a large tech company in the Bay Area in the early 2010s. The example is real, but the company names have been changed for confidentiality. The large acquiring company, Big Company, had acquired many smaller firms in recent years—so many that it had developed somewhat of a template process for efficiently closing deals and integrating the newly acquired firms into its core business. Part of management’s “checklist” was verifying that the smaller firms were Section 409A compliant. In this instance, the company being acquired, Small Company, represented to Big Company that it was Section 409A compliant. In reality, Small Company’s most recent 409A valuation was performed about 20 months prior to this acquisition discussion with Big Company. About 12 months after the initial 409A valuation, Small Company erroneously concluded that the value of the company had not changed and that another 409A valuation was unnecessary. Small Company gave the outdated 409A valuation documentation to Big Company, which caused some concern. Big Company immediately stopped the acquisition deal and would not proceed until Small Company was Section 409A compliant.
When an updated 409A valuation was performed by an independent appraisal firm, the original strike price of many options was deemed too low, triggering major tax issues for the affected employees. To resolve the tax and financial reporting related issues, Small Company was forced to ask all the employees to sign off on cancelling the options in return for a large (taxable) cash bonus, which the compelled employees reluctantly did. Once Small Company became compliant, Big Company proceeded with the negotiations and eventually completed the acquisition deal. Failing to get another 409A valuation and remain compliant cost Small Company hundreds of thousands, if not many millions of dollars and put the delayed acquisition deal in jeopardy. A concurrently performed $5,000 409A valuation would have been a much better long-term decision.
This example involves a private acquisition and does not involve an IPO; if an acquiring company takes issue with Section 409A noncompliance per internal policy, you should not expect the SEC and IRS to be more lenient on the issue during an IPO.
409A valuations should be a regular part of every company’s IPO preparation and should be performed early and often. The short-term costs of performing a 409A valuation with a specialist are very small relative to the long-term costs of avoiding the valuations or performing your own. 409A valuations must be performed at intervals no longer than 12 months, assuming regular and periodic stock option grants. However, we suggest the safest practice, and the one that will have sufficient support under scrutiny, is to hire a valuation specialist to perform a 409A valuation immediately prior to any stock option grant, change in capital structure, financial milestone, or other value-influencing event.
- Treas. Reg. Sec. 1.409A
- ASC 718
- Private conversation with a CEO of a reputable national valuations firm on March 10, 2017
- Capitalization Table: The table found in the S-1, financial statements, or other documents, outlining the liabilities and equity of a firm.
- Comps: abbreviation for comparable companies; other companies with similar size, growth, products, services, and/or outlook, often within the same or an adjacent industry.