Stocks are a great reward for an employee, and theyíll typically be happy to receive them. Some stock options have the bonus of conferring tax benefits. The IRS has some rules requiring all private companies to secure a valuation of their shares if they plan to offer deferred compensation and stock options, to ensure that the correct taxes are being paid. In order to protect themselves against any future problems, and possible penalties, all companies of any age should get a 409A valuation.
If you are considering issuing employee shares as a means of compensation, itís important that you consult with a corporate lawyer and that your employees separately consult with tax lawyers. Section 409A applies to all companies offering nonqualified deferred compensation plans to employees, including stock options, appreciation rights, qualified retirement plans and other employee grants. Before you can offer any 409A options youíre going to need a 409A valuation.
Why are 409A Valuations Important?
The more common stocks of a company must be valuated for their fair market value, and this is done during a 409A valuation. The IRS Section 409A is where this valuation gets its name from. The section, added with the American Jobs Creation Act in 2004, states:
ìSection 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.î
Stock options are considered deferred compensation. A strike price, which is the price at which an employee is able to buy equity in your company, will also be determined by the 409A valuation.
When a private company issues an employee stock option or other types of deferred compensation, there must be a fair valuation per IRS Section 409A. It doesnít matter if the business is a startup or a company like Amazon; it is required all the same. On top of this, you have to update your 409A valuation if there is a material change event which could alter the value of your stock. A material change event could be receiving new financing, settling a lawsuit, receiving a term sheet for financing, or filing a patent. After a certain amount of time they also will have to be updated. Generally, assuming there are no material change events, the valuation will be valid for 12 months. After 12 months the company must be reevaluated. As well, when a company closes a new funding round they will also have to do this.
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What Factors Influence Your 409A Valuation?
The IRS states that fair market values are able to be determined via a reasonable application of a reasonable valuation method. Further explanation is that so long as a method is applied consistently and reasonable the valuation will be accepted. Consistency is based on how other methods are performed to determine fair market value for equity. An independent appraisal will be presumed reasonable if ìthe appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.î
One of the below approaches will be used by firms that are determining the 409A to then appraise the fair market value:
This method appraises the value of your asset by comparing it to the price of similar items. This approach is a business valuation method that useful for calculation property value or as part of a valuation process for closely held businesses. You can also use this to asses the value of your intangible assets, security, or the businessí ownership interests. Whatever it is, the market approach will assess the value by studying the recent sales of similar items and make adjustments for the variation in quantity, quality, or size.
This approach is prospective due to it assessing the value by using current prices of stocks and actual transactions and sales of/between companies in the same or a similar industry. The expected future benefits from the association and shared ownership between vendors and purchasers will influence how both parties go about their operations.
Youíll want to keep in mind two factors to ensure an accurate valuation:
Are the current comparable companies being used the best companies for the comparing and contrasting.
Are the right valuation multiples derived from the stock market actively being applied to the parameters of the subject company?
This real estate appraisal method uses the net operating income (NOI) of collected rent and divides it by the capitalization rate to get the propertyís value. In order to determine the NOI an investor will take comparable properties and look at their market sales.
After determining a capitalization rate, the investor adjusts the rate based on the propertyís characteristics. One example would be if the tenants are of a higher quality than those around it then the rate would go down. Then again, if the property is less appealing than the others then it would increase the rate. The market average should be within 50 points of your capitalization rate.
This method, one of the most popular for real estate appraisal, is most often used for properties which produce an income. The remainder will use the comparison or the cost approach.
The income approach looks to see if a return of investment can be done by the business having a steady enough cash flow from its operations. The method can capitalize or discount the assumed maintainable post-tax cash flow in the future based on the operations by a rate of return. This serves as a measure for the rate of return needed by a prospective purchaser of the business reflecting the risk inherent in achieving the determined level of future cash flows.
The two main variables in this value would be the future cash flow and any risks involved in earning it. If you can manage and support these variables, the more likely that the 409A can be maximized.
This approach determines the cost of recreating the business based on its net asset value (NAV), which is the total assets minus the total liabilities. There are multiple ways to interpret this number a there is some discrepancy in deciding whatís an asset, whatís a liability, and how much those items are worth.
The conclusion of this approach is important because the overall value of the business may be influenced by underlying net tangible assets. A buyer may be interested in buying a company due to more availability to security in the financing of the acquisition, or simply because the risk can be perceived to be lower in case of bankruptcy as there are more physical assets to be able to liquidize.
How do You Acquire a 409A Valuation?
There are three options available to receive a 409A valuation report:
Use a firm: Most people end up using this method as itís a safe one. The burden of proving the value of your 409A is shifts onto the IRS. If itís overly high or low then the IRS will be forced to continue to back it. This method costs the most, however you are essentially future proofing your business against the IRS itself, so the investment seems worth it.
Use Software: This is a pretty risky choice. This option is only available to certain early-stage startups, having to meet strict criteria, such as being able to prove the you havenít raised $500,000, lack a consistent revenue, not within 180 days to an IPO, not within 90 days to an acquisition, or having less than $100,000 in assets.
Personally do it: The riskiest option is to file the 409A valuation yourself. If a mistake is made then you have no protection from the IRS. You may be able to save money doing it this way, but it can become costly later if the IRS steps in and deems your valuation to be faulty. Itís highly recommended to leave it to the professionals, or to at least be very knowledgeable on the subject of 409A valuations.
Some of the most common mistakes made during a 409A valuation:
Hiring an inexperienced appraiser. Just because a firm is cheaper doesnít mean that theyíre good at their services. Always make sure to hire a firm with a solid reputation.
Failing to get input from your companyís accountants before choosing an appraiser. IRS audits will require informed accountants, so donít leave them out of the loop.
Pushing your appraiser. Even if you want them to give you a lower strike price you should remember that they can refuse to defend your 409A valuation in the case of an IRS audit, or even flat out refuse to issue the valuation report in the first place. Remain on good terms.
Will I have to wait long for my 409A Valuation?
Considering the many factors involved itís difficult to pinpoint a return time for the 409A valuation. The following timeline should give you a rough estimate though:
Provide your data (1-3 days): This will include past 409A reports, articles of incorporation, financial projections, cap table, and term sheets.
Running the report (10-20 days): If you want your valuation quicker, expect to pay at least $1,000 to $3,000.
Revisions (1-2 days).
Youíll receive the final report (1-10 days).
Worst case scenario, it will take a little more than a month to compile all of the necessary information together and get the final 409A valuation back to you. This can be made longer however if mistakes have been found, or if the IRS has to get involved. You can minimize your errors and, thusly, pick up the pace of the process by hiring a firm. Youíll need to be accurate for the time frame.
What Happens if I donít get a 409A Valuation?
Essentially no valuation means you get to live through a horrible nightmare. The IRS will assume your assets are being given away if you donít price your stocks. Any option holders discovered to be in violation of 409A will have to pay taxes plus a 20% federal penalty, any applicable state penalties, an IRS tax underpayment penalty, and any interest on unpaid taxes. Service recipients will be held responsible for the normal withholding and reporting obligations as related to the amounts that are able to be included in the service providerís gross income, according to Section 409A. For anyone holding a stock option this can be extremely problematic as the lack of the exercise of the option and sale of the stock means that they wonít have cash to pay the taxes and interest with.