Business owners often think they have a very good idea of the value of their company – after all, they live it on a daily basis. However, a business owner (public or private) is required to go beyond his own best guess of the company’s value and seek the advice of a valuation expert in order to satisfy IRC section 409A. The private company valuation requirement stemming from section 409A applies to businesses issuing its employees traditional or non-traditional deferred compensation such as stock options (most common), employment agreements and offer letters, bonus plans, salary deferral arrangements, restricted stock units, or severance agreements.
So, if you are issuing options or any other form of deferred compensation to your employees, you must seek an expert adviser who will give you an assessment of the fair market value of your business. The valuation expert is likely to employ the asset, income and market approaches to reach an enterprise value while using such methods as the option-pricing method, the current value method, and the probability-weighted return method to allocate this enterprise value to the equity of the company, right down to one common share.
What is the root of section 409A requirements?
The requirement to get a 409A valuation of your company’s fair market value stems from the American Jobs Creation Act of 2004. The rationale behind implementing the 409A provision was Congress desire to have a tighter grip on stock option reporting (stemming from the Enron and Worldcom scandals) and because of its desire to ensure the government received its share of taxable income, something that had been avoided through undervaluation of employee deferred compensation.
Consequently, when issuing stock options or other deferred compensation arrangements to employees, you must ensure the targeted exercise price is compared with an accurate fair market value of your business’s common stock as of the option grant date (or other compensation agreement date). There are risks to getting the fair market value assessment wrong. If you underestimate the fair market value of your company, the penalties and charges include:
• 20 percent federal penalty;
• The IRS tax underpayment penalty plus an additional 1 percent (premium underpayment penalty);
• Certain state penalties and taxes (for instance, California also imposes a 20 percent state tax, interest, and penalties);
• Your employees and other service providers will be subject to regular income tax as soon as the option vests plus, if the employee doesn’t pay the tax in a timely manner, an additional underpayment penalty of 1 percent above the IRS’ general underpayment penalty;
In addition to the direct, out of pocket expenses, your funding and businesses partners may be somewhat put off by the penalties. On the other hand, if you overestimate the fair market value, your employees receive less income than they otherwise would have. That certainly will not make your employees happy.
Does it matter who I choose to perform my 409A valuation services?
Yes. Private company valuation services are generally complex and choosing a 409A valuation service that undervalues or overvalues your company introduces the risks mentioned above.
An Illustrative Example
Suppose your company’s stock is illiquid (i.e. closely-held, non-marketable, minority interest) and the fair market value of your company was $0.10 per share on the grant date. Further, assume the company ends up being sold for $1 per share. Assume you issue 1 million shares to a key employee at $0.05 per share because of an adviser’s recommendation that your company was worth $0.05 per share on the grant date.
When/if the IRS finds out, because the valuation adviser undervalued your business, perhaps due to incorrect market comparisons, spreadsheet errors, or poor valuation methodologies, your employee will be subject to the previously mentioned penalties, as well as an additional $50,000 in taxable income ($0.05 multiplied by 1 million shares). In the end, as much as 85 percent of the $50,000 could end up in the government’s hands (shown graphically below).
In a second scenario, suppose you issue 1 million shares to a key employee at $0.20 per share – again, due to your adviser’s fair market value assessment. When the shares are sold at $1, the employee is missing out on $100,000 in income. Don’t think your employee won’t notice.
Overall, when issuing most types of deferred compensation agreements (including stock options), a company is required to have a 409A valuation performed to determine its fair market value. Getting this valuation wrong by undervaluing the company, or not having it performed can lead to severe penalties imposed by the IRS. Getting it wrong by overvaluing the company and the employees receiving the deferred compensation (i.e. options) receive less income than they otherwise would have.
At Simple409A, we employ the approved valuation methods using our expert appraisers’ experience to ensure you get the right valuation for your company. We work hard to make the process easy on you so you can spend more time doing what you do best, and we have industry leading prices. Give us a call at 415-316-9274 or provide your information below, and we can see if Simple409A is right for your company.
The above information does not constitute advice, and does not create a client relationship