Article | November 11, 2022 | Authored by KDP LLP
Stock options are often used by startups and growing companies to incentivize employees and consultants, attract board members, and secure funding. While leveraging stock options can be efficient and effective, a company must value those options in accordance with IRS rules or both the company and option recipient could face significant taxes and penalties. This article will discuss how a 409A valuation helps a company adhere to IRS rules and properly price options.
409A valuations: the basics
When a startup is founded, it sets the value of its common stock and distributes shares or units among the co-founders at an exceedingly low rate, often small percentages of a cent. As the company grows, it builds value, resulting in a stock price higher than the fractions of a cent initially assigned.
At some point, a company may want to grant stock options, transact stock, or secure financing, in which case it may need to determine the current fair market value of its stock. A valuation may be required as part of the transaction or may be needed for IRS reporting.
Section 409A of the IRS code establishes rules for deferred compensation, including stock options, and from this code, the “409A Valuation” was born. A 409A valuation is an independent, fair-market valuation of a company’s stock, which is necessary when issuing stock options.
How stock options work
A stock option enables the holder to purchase a certain number of shares in a company (typically common shares) at a specific price, known as the strike or exercise price, within a predetermined period. For example, Employee A may be granted 1,000 options at a strike price of $2.00 with an expiration of 10 years from the grant date. The employee may purchase the company’s stock at $2.00 per share before the option expires, known as exercising the option.
Companies often set a vesting schedule requiring the option holder to wait for a specific period before exercising the option. For example, a company may grant a certain number of options to an employee but set a schedule where 25% of the options vest each year over the period of four years so long as the company still employs the recipient. In this scenario, the employee is incentivized to stay with the company for at least four years.
When a company grants stock options, it must set the strike price in which the recipient can purchase the stock. Per IRS rules, the strike price must be equal to or greater than the fair market value on the date of grant. Otherwise, if a company grants someone the option to purchase stock at a price lower than the current fair market value, it’s considered taxable compensation to the person.
Unfortunately, private companies don’t typically know the fair market value of their stock, especially a value calculated per IRS guidelines. A company that recently had a financing event such as the sale of equity may assume that the price per share paid by a new investor establishes the fair market value of its stock. However, this isn’t necessarily true. Just because an investor paid $10 per share doesn’t mean the fair market value of a share of stock is $10. The investor may have preferred stock or other preferences that the common stock does not provide. Thus, the fair market value of the common stock may be very different from the price paid by an investor.
When to get a 409A valuation
Typically, the first time a company needs to perform a 409A valuation is after raising the first round of capital or other financing or before issuing stock options. Once completed, the IRS allows a company to use the 409A valuation for 12 months.
The 12-month valuation period ends early if the company experiences a significant financing event, such as raising additional capital. Such occurrences mean that the company is no longer valued at what it was under the last 409A valuation. As such, it triggers another independent valuation, a cycle that repeats with each event.
409A valuations are not only for new or growing companies. Mature companies may need valuations for the same reasons – stock options, financing events, stock transactions – and they may need them more frequently. Companies will typically choose to undergo them annually but may need them quarterly or semi-annually, depending on the recommendation of management and counsel.
The cost of not getting a valuation
The real incentive for performing a 409A valuation is the cost of not undergoing one for those who hold stock options. If the IRS believes the strike price of stock options to be below fair market value at the time of grant, the recipient may face a significant tax liability as soon as the options vest. More specifically, the holder may be taxed on the difference between the strike price and the fair market value of each share at the time of vesting. Additionally, the holder may be subject to an additional 20% federal tax and possibly state taxes.
In this situation, the recipient may owe significant taxes without having bought and sold the stock. This may result in the recipient not having enough cash to pay the taxes due. Furthermore, in the case of employees, the company may be required to withhold the taxes from the recipient’s paychecks; otherwise, the company may be liable for the taxes.
The damage can be severe, if not to the company itself, to the morale of the individuals working for it.
How are valuations performed?
A 409A valuation should be performed by an independent professional. Doing one yourself takes time away from running a company and comes with enormous risk. Because owners and employees could potentially have a lot to gain if the company is valued a certain way, should something go wrong in the process – intentionally or otherwise – the company is exposed to the legal and financial ramifications that follow.
Because of the sensitive nature of valuations, how firms perform a 409A valuation is a standard process across the industry. Firms will use both qualitative and quantitative data to perform the valuation, including but not limited to financial statements, the latest updates on the company, the company’s stage of maturity, and forecasting models.
The firm may use a combination of valuation methodologies – the asset approach, the income approach, and the market approach.
• The Asset Approach determines a value by adding the market value of the assets, both tangible and intangible, and subtracting the market value of the liabilities. This approach is most useful for asset-heavy companies where most of the business value resides in the assets rather than in expected future cash flow.
• The Income Approach focuses on the value of the company’s future income and cash flow. The business value is roughly the net present value of all the company’s future income and cash flow, discounted by a required rate of return, also known as a discount rate.
• The Market Approach uses data from recent transactions of similar businesses to determine fair market value.
The result will be a valuation for the company as a whole and broken down to a value per share of stock.
This article provides only an overview of 409A valuations and is not a substitute for speaking with one of our experts. If you would like to learn more about 409A valuations and discuss your specific situation, don’t hesitate to get in touch with our office.
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