Determining the value of common shares is vital when startups grant stock options. A 409A business valuation is an independent assessment of a private company's common stock in preparation for issuing shares to workers on a tax-free basis.
The name of this valuation is from Section 409A of the U.S. Internal Revenue Code (the "tax code"). Added to the American Jobs Creation Act in 2004 "Section 409A applies to compensation that workers earn in one year, but that is paid in a future year; this is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan."
Often, new companies offer shares of stock to their workers as an incentive. It is an effective way for employees to feel invested in their work. Section 409A requires that options granted as compensation to service providers have a strike price equal to or greater than fair market value of the shares underlying the options on the date the options are granted.
However, suppose during an audit, it is revealed that those options were granted with a strike price below fair market value. In that case, the service provider who received the underpriced options can be subject to tax penalties. Getting a 409A valuation from a competent professional triggers the safe harbor provisions within the tax code that help avoid such penalties. Failure to get a 409a business valuation could create problems for your company and your employees with the Internal Revenue Service (IRS).
Why is a 409A valuation important?
A 409A Business Valuation is essential to companies and workers for several reasons. Here are a few of the benefits of getting a 409A Valuation.
- 409A valuation can protect your workers from any tax issues that may arise in the future with the IRS.
- It protects you and your company from significant bills for lawsuits or tax liabilities.
- It sets an acceptable and fair market value of your company's common shares.
- It gives management and investors a gauge of the company's financial standing.
Factors influencing a 409A business valuation
There are generally three approaches that providers use during a 409(a) valuation to appraise fair market value, They are:
- Market approach - This method involves an analysis of comparable private and public companies and transactions.
- Income approach - This approach entails analyzing a company's free cash flows to determine projections for the next five years.
- Asset approach - This requires an analysis of a company's tangible and intangible assets.
How to get a 409(a) business valuation done
There are generally options available to get a 409A business valuation report:
- Do it yourself - This is the riskiest option because there is no safe harbor protection should the IRS get involved. Therefore, it is best to have it handled by a professional.
- Use a software tool - This option is equally risky as getting it done yourself. Only specific early-stage startups are eligible to do this. Using this option would mean your company would not get ‘safe harbor' protection, and if you are audited, the burden of proof is solely on you.
- Hire a professional - Paying for a 409A is the least risky option because it offers safe harbor protection. That means now the burden of proof is on the IRS.