Stock Options and 409A Valuations in the Private Sector

Stock options can serve as an important tool for attracting new talent to your company and retaining top-quality employees or consultants. To avoid tax surprises and penalties, however, options must be issued at exercise prices set at the then-current value of the company’s stock. Although publicly-traded companies can easily determine this value, a private company has no readily available source for the current value, and therefore, must determine the fair market value of the company’s stock pursuant to Section 409(A) of the Internal Revenue Code (IRC) – hence the name “409(A) Valuation.” Despite the complexity which the term “409(A) valuation” suggests, it is not mandatory that a company engage a valuation company to perform the valuation. And if your company is a start-up with limited assets and no income, you may justifiably wonder if procuring a formal valuation is worthwhile. In fact, a company can comply with Section 409(A) without engaging a third-party valuation expert; this approach, however, is not risk-free.

Role of 409(A) Valuation
As a general matter, stock options are considered non-qualified deferred compensation (as opposed to qualified deferred compensation with a 401(k) or similar plan) because an employee or contractor is granted (or “earns”) the stock options in one year but is not paid out on those options until some future date. This literal “deferral” of payment to a different tax year makes the issuance of options a tax-free event for your employee/contractor.

To ensure such tax-deferred status, the company must set the option’s exercise price (the price at which company stock can be bought at a future date by the employee/consultant, sometimes called the “strike price”) at an amount equal to or greater than the fair market value (FMV) of the company’s stock at the time the options are granted. Since a FMV calculation for privately-held stock is complicated – and one ripe with the potential for undervaluation – Section 409(A) requires private companies to perform or have performed on their behalf a valuation in order to set the FMV in compliance with the Internal Revenue Code provision. Publicly-traded companies are of course not beholden to this process since they can easily justify their strike price by simply referencing the current trading price of the company’s stock on the day of the option issuance.

409(A) Appraisal Methods
There are several different approaches for conducting a 409(A) valuation and obtaining an assessment of the FMV of your company’s stock. First, an “asset” method will analyze your company’s assets (including tangible and intangible assets), using replacement cost to determine a company’s enterprise value. This method can be expensive and does not account for any potential growth of the company. Next, the “market” method will compare other private and public companies and transactions in order to set a reasonable appraisal of your company’s stock. However, this approach is limited by the fact that the chosen comparable companies may not be generally representative of your company’s business. Another valuation method similar to the market approach involves use of a recent valuation performed in connection with the company’s financing or fundraising activities. Known as the “backsolve,” this approach eliminates the need for building public comps. Rather than developing a company’s total equity value and then working through an equity allocation method to estimate the individual equity security values, the total equity is implied by the current financing round. Finally, the “income” method will examine your company’s free cash flows and prepare projections over the subsequent five (5) years. This method is not typically used in start-ups because there is inadequate historical financial information to support projections.

How to Secure a 409(A) Valuation
While a brand, new company may prefer to handle their valuation in-house (which is permissible under Section 409(A)), this approach involves the most risk. In this situation, the statute places the burden of proof on the company to demonstrate that its valuation is reasonable and defensible if questioned by the IRS. This option also carries with it the greatest probability of unintended errors. Even if the company utilizes software designed specifically for 409(A) valuations, the burden remains on the company to justify the valuation. Finally, conducting a self-valuation will not afford the company “safe harbor” protection in the eyes of the IRS in the way that a formal valuation conducted by a third-party professional, most likely, will.

Hiring a qualified, independent valuation firm is a much safer and easier approach for a privately held company. By doing so, the statutory burden shifts to the IRS to prove that the strike price is unreasonably low or inaccurate. Although this course of action does not guarantee “safe harbor” protection, it will save the company time and money if the strike price is questioned. Additionally, if the company anticipates issuing stock options with any frequency, it may make sense to engage a firm that offers a complete equity management solution, with a 409(A) valuation included in their initial set-up fee. There are several firms that offer reasonable pricing, particularly for start-ups. Typically, the turnaround time for a professional 409(A) valuation will be anywhere from several days to a couple of weeks, depending upon how promptly the company can provide requested diligence items.

Risks of Forgoing a 409(A) Valuation
When a company chooses to forgo the engagement of a professional to conduct its 409(A) valuation, the likelihood of an audit by the IRS increases, especially if the company sees significant growth. Although start-ups, on the whole, may avoid IRS scrutiny in their early days, this will change as they become more successful. In the event of an audit, if the IRS concludes that the option price (even inadvertently) was set below fair market value, the company and its option holders can face significant IRS penalties. For instance, option holders will be forced to pay taxes plus a 20% federal penalty, any applicable state penalties, an IRS tax underpayment penalty, and interest on unpaid taxes. Likewise, the company may face questions and intensified scrutiny from the Securities and Exchange Commission if and when it explores the possibility of an IPO. For these reasons, we recommend engaging a firm to perform a 409(A) valuation, whether the company is fresh out-of-the gate or an established unicorn.

Section 409(A) Continued Compliance
It is important to note that once a company decides to issue stock options and obtains a 409(A) valuation of its stock, Section 409(A) may require that a new valuation be completed every twelve (12) months, as well as each time the company experiences a “material” event that would affect the value of the company—whether that effect is negative or positive (i.e. on the positive side, the company closes a new funding round). If you are considering a grant of stock options for your company or have questions about the valuation process, please contact Kristin Kreuder at [email protected].

Kristin Kreuder is a Member of our NY-area team with over 23 years of legal and business experience in both public and private corporations and in major NYC law firms. Kristin handles a wide range of legal matters, including mergers and acquisitions; commercial transactions; technology, media, licensing and sponsorship; capital markets, venture capital and private equity transactions; and a variety of general corporate and governance matters.