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 appliesn and penalizes both the company and the recipient. In essence, the purpose of a 409A valuation is to avoid IRS 409A.
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”.
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 non compensatory 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.”
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.