IRC 409A Valuations – Compliance for Early Stage Company Valuations Performed For the Issuance of Common Stock Options

What Is a 409A Valuation And Does Your Company Need It?

Securities that are issued as deferred compensation and are subject to scrutiny under 409A include the following: stock options, phantom stock, stock appreciation rights, and restricted stock. 409A requires that conforming awards have an exercise price of securities awarded as deferred compensation equal to or greater than fair market value at the time the award is granted. Penalties are assessed if option strike prices are not at least at the fair market value of the common stock. Fair market value is to be determined by the “reasonable application of a reasonable valuation method.”

409A provides that a valuation is presumed reasonable if one of the three valuation methods is consistently applied. Alternatives, such as independent appraisals, formula values, and “illiquid Start-up” valuations exist for private companies to meet the requirements under 409A. The value determined by any of these methods is presumed to be reasonable unless the Internal Revenue Service (IRS) can show that it is grossly unreasonable. Ultimately, the burden rests with the IRS.

409A considers appraisals to be “reasonable” if they are performed by independent appraisers within 12 months of relevant grant dates, and if no material events transpired between appraisal and grant dates that would impact valuation. Companies within 12 months of IPO, sale, or change in control are expected to rely on this presumption. Companies with illiquid stock must show reasonable good faith efforts to meet the requirements of 409A with valuations supported by written reports. Appraisals must take into consideration certain standard valuation factors.

The illiquid stock presumption can be relied upon by early stage private companies that satisfy certain conditions. The company cannot have a class of equity securities traded on the established securities market and has to have conducted business for less than 10 years. The subject stock cannot be subject to put or call rights other than the right of first refusal or unvested share repurchase rights, and the company cannot be anticipating a change of control within 90 days or an IPO or sale within 180 days from the date of grant. Under either presumption, the person or persons performing the appraisal or valuation must have significant knowledge, experience, education, and training in performing similar valuations. This latter requirement for knowledge, experience, education, and training is not defined specifically and is therefore broadly construed to include a wide variety of professionals, some of whom may never have performed a formal valuation previously. Under these circumstances, the IRS may have an advantage in a “challenge” situation.

Contact Us To:

• Ensure that the appropriate methods to determine the fair market value of your common stock are used.
• Support your marketability discount to meet the IRS requirements.
• Prepare a 409A Valuation that can be used for both tax and financial reporting.
• Prevent issuing companies from exposure for failing to withhold or report award amounts deemed to be income.
• Prevent your employees from being personally liable for an immediate taxation–plus a 20 percent penalty tax, and potential interest payments, if your company fails to comply with 409A.

CPA, CVA and AVA Your Best Choice for Valuation Services

David L. Diamond, CPA, CVA is our partner in charge of 409A Valuations
Tel: 847-240-1040 ext. 140
Fax: 847-240-1055