409A Valuations and Why They Are Important
BY HEIN & ASSOCIATES
For closely-held private companies, attracting and retaining qualified personnel can be a challenge, particularly when competing against public firms in popular markets and industries, such as technology. For that reason, many private companies design various equity incentives – such as stock options – to sweeten the allure of an overall compensation package.
While this approach can be a successful talent management tool, many business leaders may not know that these options or other equity incentives must be formally valued by a qualified professional on a regular basis. If the company fails to take this step, both the business and employees receiving such incentive compensation could be liable for significant tax and interest penalties.
Section 409A: How it Affects Equity Incentive Compensation
Essentially, the IRS created Internal Revenue Code Section 409A: Nonqualified Deferred Compensation Plans to prevent private or closely-held businesses from issuing stock and other equity-based options at an exercise price below fair market value at the grant date. This accounting rule was adopted due to widespread abuses of deferred compensation practices, mainly by early “dot-com” companies in the late 1990s and early 2000s. At that time, many companies were issuing options at an exercise price as low as one penny, which enabled a lot of eligible employees to cash in on huge equity returns whenever those companies went public or were acquired at lofty valuations. Section 409A applies to all companies offering nonqualified deferred compensation plans to employees. As such, the valuation also affects stock appreciation rights, profit interest units and restricted stock units.
While the required fair market value determination for this type of equity compensation can be established by internal accounting or finance staff, those employees rarely possess the qualifications to properly complete the valuation as prescribed by both the IRS and the American Institute of Certified Public Accountants (AICPA). Since an accurate valuation is crucial to establishing a strike price that companies and employees can safely rely on for redeeming vested shares, it is wise to seek a 409A valuation from a qualified valuation expert.
A Closer Look at 409A Valuations
409A valuations are basically an insurance policy, which a company can rely on for protection and support if a future IRS audit claims the company did not establish appropriate fair market value for its stock or equity incentives. When this valuation is created by a qualified professional, it provides “safe harbor” protection that shifts the burden of proof for noncompliance from the company to the IRS. This peace of mind is important, since failure to comply with 409A guidelines can result in sizable state and federal tax consequences. In some cases, penalties for both the company and individual equity option recipients can total as much as 60 to 75 percent of total awards granted.
409A valuations also demonstrate good corporate governance, which could help a company more easily close any future sale of the business, assuming an acquirer follows proper due diligence by reviewing all such valuations performed on the company. On the other hand, a lack of regular valuations could negatively affect a future sale.
According to IRS guidelines, 409A valuations should be performed at least every 12 months, or shortly after any material change or development occurs in the company’s financials (such as a new equity financing). Early-stage companies typically obtain this valuation after receiving their first round of outside capital, and annually thereafter (assuming no material changes or additional outside funds are raised in the interim time period). In fact, companies progressing toward a potential liquidity event – such as an initial public offering – often increase the frequency of 409A valuations to a semi-annual (or even quarterly) schedule.
409A Valuations: Not Just for Tax Purposes
Section 409A specifically relates to the potential tax impact of deferred compensation plans (such as stock options). However, such valuations can also be useful to ensure compliance under Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which is used to determine stock-based compensation expenses for financial reporting purposes under Generally Accepted Accounting Principles (GAAP). As a result, Hein often produces dual-purpose reports that clients can use to demonstrate compliance with both IRC 409A and ASC 718.
Finding a Qualified Third-Party Resource for 409A Valuations
A 409A report is only useful if it is professionally prepared, giving business leaders confidence that assessments of fair market value for their stock or other equity incentive compensation have been calculated in compliance with IRS standards. Thus, it is smart to look for an individual or firm with a thorough educational background in finance and valuation, including significant experience preparing independent valuation reports. At Hein, our valuation team consists of professionals who meet these standards, and who have also earned one or more professional credentials from the American Society of Appraisers, American Institute of Certified Public Accountants, and the CFA Institute.
For more details on how to obtain a 409A or ASC 718 valuation for your company, contact Hein & Associates.