IRC 409A Perspectives: How It Impacts Employee Stock Options

September 19, 2022by Ravix Group

IRC 409A became applicable to employee stock in 2005. It triggered a need for private companies that grant stock options to have their common stock valued approximately once a year. Ravix Group and our partners can provide valuation and outsourced accounting services to startups and other businesses implementing or re-evaluating their stock valuation strategies.

What Is IRC 409A?

The US Internal Revenue Code Section 409A provides guidelines for the regular appraisal of common stock. The 409A valuation determines the fair market value (FMV) of private companies, and they are handled by independent appraisers. In particular, startups benefit from these assessments, using them to secure additional funding and provide a reasonable price point for employee stock purchases.

How 409A Valuations Work

When the 409A valuation requirements first took effect, the Internal Revenue Service showed little interest in their enforcement. So, it’s no wonder that it’s still a bit of a black box to many companies. However, it has transformed from a hodgepodge of ranges and techniques to a set of defined methodologies and more accurate valuations.

That’s good news for startups seeking to set up tax-free stock options to reward and attract .

There are at least two good reasons for having a 409A valuation done for your company as part of your annual compliance cycle (similar to filing a tax return):

  • A valuation creates a safe harbor that protects your employee option holders against some potentially very onerous tax penalties including federal tax penalties of 20%, comparable state tax penalties (at least in California), and being obligated to pay taxes on hypothetical stock gains before they are actually realized.
  • A valuation also protects the company from being required to withhold on real or illusory employee stock option gains as the options vest. These evaluations can also prevent the consequences of failing to properly withhold taxes from employee paychecks.

Why Some Companies Dislike 409A Valuations

For most companies, a 409A valuation is an irritant at best because:

  • It doesn’t add value to the company, so it is a very low priority for use of the company’s limited capital.
  • It takes management time away from other much more important priorities. It sometimes results in a common stock valuation, which must conform with professional valuation standards, considerably higher than the pre-409A valuation.
  • It doesn’t take into account the “10% of the latest preferred” rule of thumb. So, it may significantly increase the cost of exercising options for your key employees.

Those all are valid objections. However, with the assistance of a fractional CFO  with 409A valuation expertise, you can develop a solid way to meet the criteria without overvaluing your stock.

Major Accounting Firms Love Them, Especially During an Audit

Major accounting firms routinely attempt to use the 409A valuations in connection with their annual audits of private companies. This often has been the source of considerable delay and added cost for the companies being audited — particularly in the early years of 409A valuations.

Doing a 409A valuation “properly” is not a trivial undertaking. “Properly” means completing the task using generally accepted valuation assumptions and methods. The resulting valuation report and conclusions can be successfully defended with the IRS and your accounting firm.

There are many individuals and small valuation firms that offer to conduct 409A valuations, but not all of them have the requisite knowledge and experience to do the job properly.

What Makes the Most Sense For Your Company?

First, remember that the 409A issues only come into play for your company if you are granting stock options or providing similar equity incentives such as stock appreciation rights, to employees or other service providers. If you are not doing so, you can take a pass on 409A valuations, although your accountants may someday ask for something similar for accounting purposes.

If you are wondering whether your company has reached the point at which a 409A valuation is advisable, start with your company legal counsel. Corporate lawyers — particularly those that work with venture-funded startups — are very familiar with 409A and your best internal source of advice on this subject. However, if you’re planning to launch an employee stock option program, you may want to hire fractional CFO companies, such as Ravix Group, to oversee the effort, ensuring compliance and due diligence every step of the way.

Be pragmatic. 409A valuations have become just another one of the facts of life in corporate America. As annoying as it may be to spend time and money on something that contributes little or nothing to your value creation process, a valuation isn’t that expensive. If done properly, it insulates your employee stock options from some seriously adverse tax consequences.

When Is the Best Time to Complete a 409A?

Most companies that use employee stock options begin having 409A valuations done immediately following the completion of their first venture round (Series A), having been encouraged to do so by legal counsel. Ideally, you can complete it at an even earlier point, particularly if there is angel financing involved.

Once you have decided to get a 409A valuation done, be diligent in the selection of an appraiser or valuation firm to carry out the project for your company. In an effort to minimize cost, this issue is often not given adequate attention. However, the 409A regulations are very clear that the safe harbor created by a 409A valuation only arises if the valuation was prepared by a qualified appraiser.

How Do You Know if Someone Is a Qualified Appraiser?

The IRS regulations are thin on specifics regarding what it takes to be classified as a qualified appraiser. Consider the following as minimum requirements:

  1. Extensive previous experience doing 409A valuations
  2. Valuation accreditation by at least one of the professional valuation organizations (AVA, NACVA, AICPA, etc.)
  • A thorough understanding and significant experience applying the allocation methods described in the AICPA Practice Aid related to the valuation of private company equity securities.
  1. Experience working through valuation issues with accounting firms

When you are in the evaluation and selection process, narrow your candidate group to those who pass the qualifications test before applying the price screen.

Price Point Considerations for Choosing an Appraiser

It only makes sense to be price sensitive when you are buying something that is low on your priority list. However, many early-stage companies seem to focus on price exclusively or above all else. But if the low-price offer isn’t from someone who clearly passes the qualifications screening, why take a chance?

Many well qualified appraisers are very price competitive. The cost of not using the lowest price offer is likely to be a couple of thousand dollars at the most. The cost of being wrong on qualifications issues could be orders of magnitude greater for the company and its option holders.

Ravix Group offers the best outsourced accounting services to help you determine whether a 409A valuation would benefit your company. You can avoid penalties and auditing headaches by bringing on experienced Ravix Group accounting and finance consultants to help you make the right decisions. Contact us online or call (408) 216-0656 to today to set up an appointment regarding 409A due diligence and all your accounting needs.

 

https://a16z.com/2020/02/13/16-things-about-the-409a-valuation/

 

 

 

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