Companies request a 409A valuation to determine the value of the equity in a private company. That equity value is then typically used to establish the strike price of options granted by the company. If the strike price of the options is at or above the 409A value, then there is no issue. The risk to the company comes in the event options have been issued with a strike price below the company’s true value, in which case IRS Reg 409A kicks in and penalizes both the company and the recipient. In essence, the purpose of a  409A valuation is to avoid IRS 409A.  Vinod-any other reasons for 409a’s?

The Regulation

The Section 409A  of the internal revenue code was enacted in October 2004 and was generally effective on January 1, 2005. Section 409A generally provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.

The stringent requirements under the Section 409A regulations could cover issuances of stock options (including ISOs) if the strike price of the issued stock options is lower than the Fair Market Value as of the date of grant. This could lead to several adverse tax implications to the stock option holder including (1) Accelerate recognition of taxable income (2) a 20% additional Tax additional penalty and (3) significant burden on the board members and the company to withhold taxes.

The Section 409A has provided additional guidance and “safe-harbor presumption” on the determination of the Fair Market Value of a closely-held company’s stock. As per the regulation “….., a valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock”.

Safe Harbor presumption for valuation of closely held stock per Section 409A

The regulations provide a ‘safe harbor’ for those firms who hire credentialed outside appraisers to determine an equity value for 409A purposes.

 “The final regulations adopt a presumption in specified circumstances that, for purposes of section 409A, a valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where

• The valuation is based upon an independent appraisal,
• A generally applicable repurchase formula (applicable for both compensatory and noncompensatory purposes) that would be treated as fair market value under section 83, or
• In the case of illiquid stock of a start-up corporation, a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock..”

How Omega Valuations can help you

Valuing the equity of a closely-held venture backed company, or a company with multiple classes of securities can be extremely complicated. Varying rights and preferences for different classes of securities must all be accounted for in establishing the value of any individual class, whether common or preferred.

Omega Valuations can help you arrive at the Fair market Value of the common stock for compliance under IRC 409A.  Over the past five years, we have developed significant expertise in this valuation field and have helped hundreds of companies in their Section 409A compliance.  In our valuation engagement, we consider all the factors prescribed under the regulation to ensure compliance and understand the nuances of factoring the complex capital structures associated with venture backed companies for arriving at the Fair Market Value .

FAS 123r

ASC 718 Stock Compensation encompasses the newly codified rules related to GAAP reporting of equity compensation, usually stock options, in privately held companies. With ASC 718, the value of the compensation is calculated, and then expensed by the company and reported as income by the recipient. For stock option valuations, an equity value is required, thus we often pair a 409A engagement with our ASC 718 work. We have performed numerous 409A and 123r/ASC 718 engagements since the rules were put into place. We have worked with many venture backed, technology companies, from the start up/pre-revenue/pre-product stage up through multiple rounds of financing. We work with the some of the most exciting start up companies in the US, and work with many of the top law firms and accounting firms in Silicon Valley and the Bay Area.