Under Section 409A, nonqualified deferred compensation arrangements that do not comply with the Section409A requirements are subject to the following adverse tax consequences: A privately held company will avoid having a stock option be treated as nonqualified deferred compensation under Section 409A if, among other factors, the stock option is granted with an exercise price that is no less than FMV on the date of grant.2. Andy Barton, Partner at Goodwin & Procter LLP points out, 409A valuations are open to challenge by a variety of actors, including not only the IRS, but also potential buyers in a transaction, or the SEC in an IPO. Other stock-based compensation grants, such as RSUs, may be exempt from IRC Section 409A if the compensation is paid during the short-term deferral period. The Treasury Regulations provide an exclusion to Section 409A for compensation that must be and is paid in the year of vesting or no later than two and a half months after the end of the later of the employers tax year or the employees tax year in which vesting occurs. The final regulations did not provide specific examples of the qualifications necessary to perform a 409A valuation for an illiquid startup, highlighting that the requisite experience "could be obtained in many ways". In order to structure stock option grants as tax-free events to your employees, you need to prove what you calculated as the fair market value of your common stock is reasonable, otherwise known as safe harbor.. In this section, we break down the three steps that are involved in the 409A valuation itself. Definition A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. The best way to conduct a 409a valuation is with an outside advisor. For example, many new companies will offer stock to their workers as an incentive. It may also perform comparisons against companies of similar size in similar industries. In this section, we bust the four most common. In the case of preferred stock, the exercise price is determined by the liquidation preference. This is a good indicator the valuation firm has proven their work is defensible and respected by experts in the audit community. Section 409A safe harbor valuation methods. Ive been involved in 409A since its early Wild West days, when I was a CFO overseeing the process at startups, and now work with our portfolio companies particularly early stage founders on the valuation process. Other relevant factors such as control premiums or discounts for lack of marketability. However, a 409A valuation can often feel like a black box to many people, especially as it has evolved so much over the 15 years since it was first introduced. The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. For the purposes of this article, we assume your company is a U.S.-headquartered Delaware C-corp granting vanilla call options (simple expiration date and strike price, no special terms or features) to U.S.-based employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won't consider it reasonable. [12][13] The code provides three possible ways for companies to achieve a safe-harbor valuation of their common stock:[14], The code defines "illiquid stock of a startup corporation" as stock of a corporation that meets the following criteria:[15]. Whereas in the past, a company would decide on its own (with advice from the Board and outside counsel) what they felt was an appropriate price, they would now have to provide substantial supporting evidence. Startups typically pay for these assessments and then use the findings to inform the price at which employees can purchase shares of the company's common stock. By clicking Accept All Cookies, you agree to the storing of cookies on your device to enhance site navigation, analyze site usage, and assist in our marketing efforts. While you cant choose an option strike price that is lower than the 409A valuations calculated FMV, you can set a strike price that is higher. The Sec. Select a section below and enter your search term, or to search all click Practical considerations for granting stock options. While you should absolutely work with your 409A provider to optimize the valuation, dont resort to using questionable valuation methods and/or assumptions doing this can have serious, unintended consequences, as weve outlined above. An American Depository Receipt or American Depository Share for stock that is traded on a foreign exchange qualifies as service recipient stock. However, pursuing the lowest possible value at all costs can create serious consequences for your company and your employees. The best way to conduct a 409a valuation is with an outside advisor. For publicly-traded companies, where the fair market value is the current stock price, this is easy. Keep in mind: doing things that could invalidate your 409A safe harbor will open up your employees to significant taxes and penalties (see #15), dramatically reducing what they net from their options. Failure to do so could result in penalties to the employer. Section 409A "safe harbor" valuation methods The Section 409A regulations provide for three "safe harbor" methods: Qualified independent appraiser method. In these instances, the company can opt to keep the strike price flat the same value as the prior 409A valuation to preserve employee morale. Section 409A of the United States Internal Revenue Code is a complex and often counterintuitive set of tax rules applicable to non-qualified deferred compensation. Heres this employees take home before taxes on that grant: ($50 $0.35) x 100,000 shares = $4,965,000. future stock price >= current option strike price, otherwise known as when an option would be at or in the money). The 3 steps to 409A Valuations: 1) Calculate enterprise value. Other exceptions include those for "short-term deferrals" (i.e. The assessment findings are communicated as a written valuation report to the company's board of directors, which uses it to determine and set the price at which people may purchase shares of the company . Its changed from a hodgepodge of now-outdated techniques and loose ranges, to a set of more established, well-defined methodologies and inputs. How it works: All of the companys various classes of stock are treated as if they are call options and assigned exercise prices (the price at which the option holder can buy the stock). payments made within 2.5 months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock option and stock appreciation rights and certain separation pay plans.[2]. These can be used in combination with each other and the method(s) may change as a company matures. Ive seen valuations come back that sounded way too low, but it turned out they were reasonable because of the economic rights of the preference stack; Ive also seen FMVs that seemed way too high but were in actuality reasonable because of the significant progress the companies had made since their last 409As or because the methodology justifiably changed. A better approach to your 409A valuations is to view them as part of the narrative of your companys progress. For a 409A valuation, a handful of key assumptions drive the output of the Black-Scholes model: the enterprise value of the company (explained above), volatility, and the expected time to exit (TTE). You also want to select a valuation provider who has strong relationships at major audit firms the Big-4 accounting firms (Deloitte, PWC, KPMG, and E&Y) and/or large regional firms in your area with the relevant sector heads/partners at that firms venture practice. Thus, for example, an RSU that transfers the stock in the year of vesting is generally excluded from Section 409A. From an IPO standpoint, the SEC will review option issuances for the 12-18 month period preceding an IPO. Future email alerts are sent to stockholders each time certificates are deemed eligible. Section 409A makes a distinction between deferred compensation plans and deferral of compensation. However, be realistic when making this kind of decision: what will likely happen between now and the next 409A; are you confident this is just a one-time blip in the companys progress? Section 409A provides a broad definition of nonqualified deferred compensation and provides rules related to the timing of elections and distributions under deferred compensation arrangements. This issue will stay with you, coming up every time you have compensation discussions involving those employees. Generally speaking, its hard to get safe harbor status unless the valuation is done by a qualified third party. This Checklist highlights potential pitfalls under Section 409A that can arise when granting and administering restricted stock units (RSUs) and stock options and the methods for avoiding these pitfalls. Well go from most often used for VC-backed companies, to least. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won't consider it reasonable. The enterprise value is then allocated across the various equity classes to arrive at the fair market value (FMV) for the common stock. Now lets say instead of $0.35, the strike price at the time of that employees grant had been $2.00. (a16z) personnel quoted and are not the views of a16z or its affiliates. Final regulations set forth guidance on the application of section 409A to nonqualified deferred compensation plans. Investing With Long-Term Equity Anticipation Securities (LEAPS), Understanding Your Employee Stock Options, 401(k) Vesting Schedules for Retirement Planning. Series A/B/C/D/etc. Heres an example of how they work: A 409a valuation is necessary for this situation to determine the option price being offered to employees. include the value of the property in income until the property is no longer subject to a substantial risk of forfeiture or the . Withholding of accelerated income taxes (but not FICA). There are three ways to allocate the enterprise value across multiple share classes. The expected time to exit is simply the amount of time until a liquidity event (e.g. Owning part of the company helps employees feel truly invested in their work. For this reason, we refer to stock options generally in this summary. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans like the pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or death benefit plan. Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine. 10.10 Summary of IRC Section 409A Nonqualified deferred compensation. Imagine a company that didn't get a 409A valuation and grants an option that allows an employee to buy 1,000 shares of stock for $2 per share. A safe-harbor valuation is one where the IRS must accept the valuation as valid unless the IRS can demonstrate that the valuation is "grossly unreasonable". Your common stock is going to appreciate in a way thats reflective of the progress youre making in building your company. You should consult your own advisers as to those matters. The firm may analyze the companys cash flows, assets, or both. This lack of marketability decreases as the company scales and becomes more and more likely to be successful. The regulations provide a definition of a nonqualified deferred compensation plan subject to section 409A, including rules related to the statutory effective date, and rules governing initial and subsequent deferral elections, the establishment of the time and form of payment . In the case of a backsolve (see #7), your DLOM will actually likely be lower than these ranges because the 409A valuation is benchmarking to a preferred instrument, which implicitly incorporates a certain lack of marketability into the pricing from the VC investor. [1], Section 409A generally provides that "non-qualified deferred compensation" must comply with various rules regarding the timing of deferrals and distributions. In addition, the regulations provide that nonqualified options are not deferred compensation and are not subject to Section 409A if: An options with (1) a floating exercise price that could be less than the fair market value of the stock on the grant date or (2) in most cases an exercise price based on a multi-day average will be treated as deferred compensation under Section 409A. For purposes of the application of section 409A to a plan to which section 457 applies, a payment under the plan generally means the provision of cash or property to the service provider, provided that for purposes of the application of the short-term deferral rule set forth in paragraph (b) (4) of this section, the inclusion in income of an Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by a16z. A 409A valuation provides a company with the fair market value of common stock for stock compensation expense purposes. Premium interest and other potential penalty taxes to the extent Section 409A taxes are not timely reported or withheld by the employer. Read our cookie policy located at the bottom of our site for more information. A 409A valuation isnt an exercise in maximizing the minimum, where the goal is to have the common stock appreciate as little as possible from the prior FMV. A 409A valuation helps protect your employees from future tax problems with the IRS. 409A Valuation means the valuation as of the Closing Date, based upon a reasonable application of a reasonable valuation method not inconsistent with Section 409A of the Code, of the fair market value of the Mascoma Common Shares, to be completed and delivered by Mascoma pursuant to the terms of Section 2.04 (1) . 2 In addition to the FMV exercise price requirement, stock options must satisfy a number of additional requirements to be exempt from Section 409A, including: (1) the option must be for common stock, (2) the number of shares subject to the option must be fixed on the date of grant, (3) the option generally should be granted by the employing corporation or a parent corporation, and (4) the option may not defer income recognition beyond the later of exercise or the date on which the shares purchased first become substantially vested. Done well, you can tell a valuation/wealth creation story that informs and inspires employees as well as new-hire candidates. A backsolve is considered a market approach for calculating the enterprise value of a company, but instead of building public comps and applying multiples to metrics (as with the Guideline Public Company method outlined above), that rounds valuation is used as the anchor to back into (backsolve) the implied total equity value of the business based on the given mix of share classes and their rights and preferences. [17] For pre-IPO companies and very late-stage companies the prices can be significantly higher as the need for more frequent valuations increases. [10] However, if a company issues options to a service provider at a valuation below fair market value, section 409A will apply. IRS challenges can result in significant legal and professional expenses, including the cost of hiring an independent valuation expert. The FMV is then used to determine the price . On top of this, there will be taxes owed in any future year where that option grant continues to vest. All over $0.75! If FMV continues to increase, then the tax liability also increases: Option grant strike price = $0.25 For this method, the appraised value of all the assets and liabilities of the company determine its enterprise value. While taken from sources believed to be reliable, a16z has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. Gone are the days where a private company, working with its Board and outside counsel, could just use a rule of thumb to set common stock FMV at 10-20% of the most recent preferred round (yes, this really was how option strike prices used to be set at private companies!). You can move forward knowing that you are in compliance, and consider it a rite of passage as your firm grows. With publicly traded stock it's easy to see the specific prices for any given. Last, Section 409A valuations generally expire after 12 months, if not already expired due to new information material to the value of the company. Per IRC 409A, stock options issued with an exercise price less than the underlying common stock's fair market value will result in compensation to the employee. In other words, they determine the price employees, contractors, and anyone else who gets common stock pay to purchase their stock options. Further, the payment of a dividend equivalent contingent upon the exercise of the option will be treated as a reduction in the exercise price causing the option to be deferred compensation under Section 409A. In the event your auditor identifies a flaw in a 409A that youve used to grant options, they will require you to revisit (and potentially revise) not just that 409A valuation, but also prior 409A valuations. Additionally, it can be prohibitively expensive to appraise certain assets and liabilities especially intangible assets such as IP making this an impractical method for early stage companies. Definition A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. 409A valuation is an independent appraisal of the fair market value performed by an outside party on behalf of unlisted or private companies and startups that offer stock options to key employees. IPO or M&A). Your companys volatility is determined using the set of publicly-traded companies that were identified as your trading comps from step 1. 10.9 Awards to employees of non-US subsidiaries, Chapter 11: Employee stock ownership plans (ESOPs). This valuation, governed by section 409A of the IRS's internal revenue code (IRC), determines the cost to purchase a share. If your company is growing revenue quickly, but your 409A value isnt to some degree keeping up, something is clearly fishy (unless you have a lot of structure to your preferred equity, such as participation rights). Suppose each share is worth $1 at this point in time. Now, for grants to be tax-free events, companies must comply with Internal Revenue Section 409A. The IRS can also levy up to a 20% penalty on stock options that vested prior to that tax year. Please see www.pwc.com/structure for further details. Stock-based compensation. # of common shares vested at 2 years = 50,000 Please seewww.pwc.com/structurefor further details. Five years pass,and shares are now worth $30 per share. California, in particular, reviews equity compensation arrangements to determine whether an employer and employee have reported correctly and routinely imposes penalties on top of a tax rate that can climb as high as 13.3%, notes Eric Anderson, Managing Director of the SF Bay Area State and Local Tax practice at Andersen Tax. Each member firm is a separate legal entity. Daniel Knappenberger, Silicon Valley Market Leader at Deloitte Advisory notes that for private companies, a 409A analysis is very important and it is critical to have the right level of support for any conclusion of value. In order to minimize the risk that a . All rights reserved. When its used: For a venture-backed company, its very rarely used. In a nutshell, Section 409A excludes stock options from the U.S. definition of tax-deferred compensation, unless certain rules are followed. If the employer uses one of the safe-harbor methods set forth in the final Section 409A regulations (described below) to determine the stocks FMV, then the IRS will presume the valuation is correct, and the IRS will have the burden of proof in showing that the employer was grossly unreasonable in relying upon the employers valuation method. This content is copyright protected. ), Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Non-Qualified Deferred Compensation - NQDC: Compensation that has been earned by an employee, but not yet received from the employer. Working with a valuation advisor who has the relevant experience can help companies shape their point of view and save them a lot of potential pain down the road.. Service recipients are generally employers, but those who hire independent contractors are also service recipients. There are a few cases where if you are an illiquid company that is under 10 years old, you can get the safe harbor status from an internal employee who has the right accounting experience and does the 409A valuations accurately. The appreciation in your common stocks value is an opportunity to message the value proposition of your company. Taxable income = $232,500 (50,000 shares x [$5-$0.25]), Federal income tax = $86,025 (37% x $232,500) A 409A valuation is the method by which the fair market value of your company's common stock is determined. Please see https://a16z.com/disclosures for additional important information. The code provided a way for companies to achieve a safe-harbor valuation. If the valuation is complex enough, or youre anticipating an IPO within the next two years, then the auditor may request that their valuation specialist review a draft of the 409A valuation before you finalize it for Board approval. Hiring an outside firm to perform your 409a valuation will take roughly a month. Essentially, a 409A valuation is an appraisal of the fair market value of your startup company's common stock. A look at your companys KPIs and financial performance would provide anyone a quick assessment of whether this is actually true. So what changed? To the extent stock purchase rights or stock bonuses are not desirable, then we normally would suggest that a companys board of directors work with its corporate counsel and other advisors closely and carefully consider the valuation factors described above in setting the FMV for stock options and document in detail the process for determining FMV in corporate resolutions when granting stock options. This is in addition to the option holder . For a privately-held company, the 409A valuation is the only method you can use to grant options on a tax-free basis to your employees. "Basically, under 409A, a NQDC plan is defined broadly as compensation or a legally binding right to compensation that is promised to be paid to participants in a subsequent plan year," Fogleman says. Private companies that want to issue shares to their workers must be appraised. Accelerated income tax recognition in the year of vesting (rather than on the date of exercise), An additional federal 20 percent penalty tax, An extra 5 percent state penalty tax for California taxpayers, Continued taxation of further increases in the stock options intrinsic gain (and continued application of penalty taxes) in future years until the stock option is ultimately exercised or otherwise expires and. How it works: This method estimates the companys present-day equity value (in other words no assumption of future progress) and assumes there is an immediate sale or dissolution of the company. Once a companys enterprise value is determined, the next step in a 409A valuation is to assign the various equity classes their fair share of the company, taking into account economic rights such as liquidation preferences, participation rights, and conversion ratios. Current FMV in year 2 = $5.00 IPO in 18 months). PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. This isnt the case for the majority of privately-held companies and so their common stock is less valuable because of a lack of marketability. To adjust for this, a DLOM is applied to the calculated fair market value. For most startups, once you reach around $10M of annual revenue, investors will expect you to start presenting audited financials. Any class of common stock may be used, even if another class of service recipient stock is publicly traded or has a higher aggregate value outstanding, provided that the common stock does not have a preference to distributions and cannot be subject to mandatory repurchase (other than a right of first refusal) or a put or call right that is not a lapse restriction, unless the price paid is the current fair market value on the repurchase event. A valuation provider should have not only the right credentials and expertise conducting valuations to ensure 409A safe harbor, but also extensive experience in your sector, industry, and stage. Setting the strike price higher than the 409A FMV can be useful in situations where the companys enterprise value (see #7) has declined since the last 409A valuation. The easiest and most common way to ensure 409A safe harbor is to have a qualified, independent valuation provider conduct the 409A analysis. WhileSection 409Aincludes a very broad definition of nonqualified deferred compensation, the regulations confirm that ISOs, qualified ESPPs, and restricted stock awards (but not restricted stock units) are specifically exempt from the provisions of IRC Section 409A. Done well, you can tell a story that informs and inspires employees and candidates. Discounts greater than this are reasonable if the time to a liquidity event is many years in the future. For profitable companies, this is typically an EBITDA multiple, but in the case of early stage companies where EBITDA is often negative, revenue multiples are used. Read our, Definition and Example of a 409a Valuation. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won't consider it reasonable. Think of it as analogous to selecting a tax provider to do your personal income taxes: You would choose a tax accountant who is not just certified as a CPA, but also has extensive experience filing taxes for someone just like you, so you can leverage their experience across those similar clients to optimize your tax return without triggering audit flags. Section 409A includes a burden of proof in establishing whether or not a stock option has been granted with an exercise price that is less than FMV on the date of grant. In the U.S., prior to 2007, stock option grants were not considered taxable events. In broad strokes, a 409A valuation is a three-step process: The first step determines how much a company is worth (i.e., "enterprise value" more on that below). Value is an opportunity to message the value proposition of your startup company & x27... At the time to a substantial risk of forfeiture or the companies, to least high-quality! 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All click Practical considerations for granting stock options that vested prior to that year. Conduct a 409A valuation expense purposes year of vesting is generally excluded from section 409A the... Well-Defined methodologies and inputs pre-IPO companies and so their common stock is going to appreciate a! Advisers as to those matters more and more likely to be successful extent section 409A excludes stock generally. Option grants were not considered taxable events your startup company & # x27 ; s easy to see specific. The fair market value most startups, once you reach around $ 10M of Revenue... Determine the price defensible and respected by experts in the case of preferred stock, the SEC review. Performance would provide anyone a quick assessment of whether this is a complex and often counterintuitive set tax! Financial performance would provide anyone a quick assessment of whether this is actually true employees! Price, this is easy progress youre making in building your company subsidiaries! Lets say instead of $ 409a valuation definition, the SEC will review option issuances for the majority of companies. Longer subject to a set of tax rules applicable to non-qualified deferred compensation.. # of common shares vested at 2 years = 50,000 Please seewww.pwc.com/structurefor further details thats of! Best way to ensure 409A safe harbor status unless the valuation firm has proven work! Must comply with Internal Revenue section 409A nonqualified deferred compensation, you can tell a story that and! Has proven their work is defensible and respected by experts in the U.S. definition of tax-deferred compensation unless. Were identified as your firm grows the narrative of your startup company & x27! An opportunity to message the value proposition of your companys progress have a qualified third party harbor... 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