Founders and management should familiarize themselves with 409A valuations early in the company’s life. Section 409A of the Internal Revenue Code will come into play once you start to think about hiring. We’re here to help and we’ve brought in the big guns. We’ve enlisted friend of EquityZen and business valuation guru Bo Brustkern to answer fundamental questions about 409A valuations. This is the first in a series of blog posts on 409A valuations, and future posts will address more nuanced topics.
Bo is Managing Director and founder of Arcstone Partners,[1] a business valuation firm, and he has over 17 years of experience as an investment and valuation professional. He has been quoted in a variety of publications, including The New York Times and Financial Times. The format is Q&A—let’s get right into it…
EquityZen (EZ): What is a 409A valuation?
Finalized in April 2007, Internal Revenue Code section 409A applies to discounted stock options and stock appreciation rights (SARs) defined as deferred compensation.
Under section 409A, stock options that have an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges. In short, the consequences for noncompliance, which affect the individual who holds the options and not the issuing company, are significant.
To avoid these consequences, management teams can issue options with an exercise price at FMV, and section 409A provides clear approaches on how to develop compliant policies. These safe harbors shift the burden of proof of noncompliance to the IRS. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the FMV.
EZ: What are the key inputs in determining a 409A valuation?
It depends on the stage of the company and complexity of transactions, but factors considered include financial statements (historical and projections), capital structure/rights and preference of securities, market/industry outlook, business model/outlook, public comparable companies/comparable transactions, and expectation/probability of timing for exit and failure.
EZ: At what point is a company required to do a 409A valuation?
A company must do its first 409A valuation prior to the first issuance of stock options.
EZ: How often must a company do a 409A valuation?
A company must do a 409A valuation every 12 months at a minimum, and any time a major change has occurred that either reduces risk or materially changes forecasts. Practically speaking, this means after a new round of financing is raised), or after any transaction involving the company’s assets (e.g., the company has acquired another, or divested itself of material assets).
EZ: What is “fair market value”?
Fair Market Value (FMV) refers to the age-old standard of value to which the IRS adheres. Fair Market Value is defined in IRS Revenue Ruling 59-60 as:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
Revenue ruling 59-60 goes on to say that:
Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.
There is also Fair Value (FV), or the GAAP valuation standard, which is defined by the Financial Accounting Standards Board (FASB). For 409A purposes, the FMV is the standard of relevance; but most 409A valuation reports these days comply with both FMV and FV standards.
[1] Arcstone Partners is a business valuation specialist firm whose bread and butter is 409A valuation for tech companies. Clients include Instagram and Quora.
This post originally appeared here.
Read part 2 here.