ESOP's (employee stock option plans) are of interest to most startups. There are too many aspects of ESOP's to cover in a single, short post. One aspect, however, that is critical is the proper valuation of the shares of stock underlying options to be issued to a company's employees from such a plan. There are a number of ways that the stock can be valued, but getting to a fair and reasonable valuation is legally critical. Most startup founders and management teams eventually come to hear the term, “409A valuation,” though many find the concept intimidating or confusing.
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What Is Section 409A of the Internal Revenue Code?
Section 409A of the Internal Revenue Code (the "Code") governs the taxation of non-qualified deferred compensation plans. This section was enacted in 2004 as part of the American Jobs Creation Act and applies to any deferred compensation plan that not covered by another section of the Code, such as a qualified retirement plan or a non-qualified annuity contract.
In addition to setting strict requirements for non-qualified deferred compensation plans, Section 409A also imposes significant penalties for non-compliance, including additional taxes and interest charges on both the employee and the employer.
The policy purpose underlying Section 409A is to prevent companies from providing employees with excessive tax benefits by deferring compensation into the future. The 409A rules are designed to ensure deferred compensation plans are structured in a way that is fair and equitable to both the employer and the employee.
What Is A 409A Valuation?
A 409A Valuation (which gets its name from Section 409A of the Code) is a process that determines the fair market value of a company's common stock that underlies stock options granted to employees in a manner that is intended to comply with the Code and related regulations. That value of the stock is then set as the exercise price (also called the “strike price”) for the options; the strike price is the price that the option holder has to pay to purchase the underlying stock after the options are vested.
Section 409A provides for three “safe harbor” valuation methods under section 409A regulations. The single-most important benefit of a safe harbor valuation is the presumption made by the IRS that the valuation is accurate and complies with the law and resulted in a reasonable determination of the fair market value of the stock that underlies the options. The three safe-harbor presumptions are:
- Independent appraisal presumption
- Binding formula presumption
- Illiquid startup presumption
Of the three safe-harbor valuation methods, the valuation method that results in the first presumption is the most commonly used. This valuation method requires a qualified, independent and reputable third party to determine the fair market value of the shares of stock underlying the options.
While a company is not required to use one of the three safe harbors for valuing stock options or stock appreciation rights (SARs) granted to its employees, is one of the safe-harbor valuation methods is not used, the risk of non-compliance with Section 409A and its related regulations is significant. And, the penalties for non compliance can be harsh, even draconian ... and not just for the company. Non-compliant stock options may subject both the company and its employees to significant tax penalties (including the founders). Companies, especially startups, should carefully consider the most appropriate safe harbor for their situation and consult with both legal and financial advisors to ensure compliance with Section 409A.
What Is The Purpose Of A 409A Valuation?
The purpose of a 409A valuation is to ensure that the stock options given to employees are valued fairly, so that they are not subject to excessive taxes when they are exercised. If a company grants stock options with an exercise price that is lower than the fair market value of the underlying stock, it can result in a taxable event for the employee, even if they have not sold the stock.
How Is A 409A Valuation Calculated?
To determine the fair market value in a 409A valuation, a professional appraiser will gather information about the company and use specific factors. The factors can include:
- The issuing company's financial performance
- The industry in which the company operates
- The company's growth prospects
- The value of the company's tangible and intangible assets
- The present value of the company's future cash flows
- The market value of similar entities engaged in a substantially similar business
Other relevant factors that might be used include control premiums or discounts for lack of marketability, and recent arm's length transactions involving the Company's capital stock.
It is important to note that a 409A valuation must follow the strict guidelines set by the IRS. Among other things, the valuation must be done within 12 months before the grant date of the stock options, and the results must be documented in writing.
A 409A valuation is a crucial step in ensuring that the stock options granted to employees are valued fairly and that they are not subject to excessive taxes. It is a complex process that must be performed by a qualified appraiser, but it provides peace of mind for both the company and its employees.
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Contact an experienced corporate & securities attorney if you are contemplating investing in a venture capital seed round in a startup, or if your company is considering seeking seed round venture capital financing. Make an appointment now for a free consultation.
I have become very impressed with the efficiency possibilities of AI. So, I gave ChatGPT a try. I generated this text in part with GPT-3, OpenAI's large-scale language-generation model. After it generated its own draft language, I reviewed, edited, revised, and expanded on it to my own liking and to ensure accuracy in all material respects. WLF takes ultimate responsibility for the content of this article.
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