Does My Company Need a 409A Valuation?

Have you heard of IRC Section 409A and wondered if it applied to your company? Do you think you might be in need of a 409A valuation but are unsure? Most entrepreneurs have never heard of IRC Section 409A. If you are planning on issuing any form of deferred compensation e.g. stock options or restricted stock then you will need advice on when and how to perform a 409A valuation.

What is a 409A valuation?

A 409A valuation is a determination of the fair market value of your company, using IRS and AICPA standards of valuation, at a specific point in time.  IRS Section 409A stems from the American Jobs Creation Act of 2004. The rationale behind implementing the 409A provision was the necessity to have tighter standards for stock option reporting and to ensure the government received its share of taxable income. In a nutshell Section 409A means that when you issue stock options or other deferred compensation arrangements to employees, you must ensure the targeted exercise price is compared with an accurate fair market value of your company’s common stock as of the option grant date (or other compensation agreement date).


How do I comply with Section 409A?

Before you issue any deferred compensation you need to determine the fair market value of your company and the stock you are going to issue. There is safe harbor that is provided when you hire an independent firm to perform a 409A valuation for your company. The independent firm will gather information about your company and determine a recommendation of the fair market value of your company and stock as of a specific date, the ‘valuation date’. You can then use the recommendation to help your Board determine at what price the deferred compensation should be issued. Ultimately, it is up to the company and its Board to determine the issue price, but if the IRS audits your company or your employees and asks how the issue price was determined you can show them the 409A valuation report as a piece of supporting evidence.


What happens if I do not get a 409A valuation before issuing deferred compensation?

If you issue deferred compensation below your company’s fair market value then the penalties and charges include:

  • 20 percent federal penalty
    • The IRS tax underpayment penalty plus an additional 1 percent (premium underpayment penalty)
    • Certain state penalties and taxes (for instance, California also imposes a 20 percent state tax, interest, and penalties)

In addition to the direct, out of pocket expenses, your funding and businesses partners may be put off by the penalties. On the other hand, if you overestimate the fair market value, your employees receive less income than they otherwise would have and will be unhappy.

What are 409A Valuation for Technology Startups

In the very first years of a company’s history, it can be difficult to provide a proper business valuation due to the fact that there is little data by which to come to a conclusion regarding that company’s value. Internet and technology businesses may take several years before seeing any significant revenue and are often inaccurately valued as a result. Traditional methods that accountants use to determine a section 409A valuation for small technology startups such as the income approach may not provide a fair assessment. We use a combination of several different approaches when assessing a company so that important information is not left out in the process.

Discounted Cash Flow Often Has No Place in Early Stage Technology Company Valuations

The purpose of a company appraisal is to evaluate its past success and its potential value in the future to investors or acquirers. Discounted cash flow analysis is based on a concept called “the time value of money” which calculates the present value of a steadily growing stream of after tax profits, or “free cash”. Newer internet and technology companies often have no significant free cash flow that can be used to determine the company’s direction, and revenue projections are generally too unreliable to determine the potential value in the future, making discounted cash flow of little value when trying to determine the value of the company.

The Market Approach Can Be a Good Method for Startup 409A Valuations

By comparing a business with other businesses that are similar in nature and size, it is possible to perform a company appraisal on the basis of a side by side comparison. Data from acquisitions and investments in startups can provide a clear picture for experienced appraisers. Factors are taken into account such as initial investors and how the company has grown compared to its peers. An assumption is made that similar companies in similar industries will be of comparable value. If there is insufficient data to value a startup company using other methods, comparing it to its peers is a viable option.

Tying the Business Valuation Together Using Multiple Approaches

Where a discounted cash flow analysis may fail to provide an accurate and reliable private company valuation, other methods can be employed. At Oxford Valuation Partners, we understand that it is important to address your 409A valuation from several angles in order to provide a fair appraisal. This is why we do not rely solely on traditional methods, but consider how your business compares to similar businesses in your field and the assets that your business has available to grow and invest in its future. For more information or to get started with your 409A valuation give us a call today.

Who can I talk to about my company’s 409A requirements?

We would be happy to give you a free consultation to see if your company needs a 409A valuation. At Oxford Valuation Partners, we employ the approved valuation methods using our expert appraisers’ experience to ensure you get the right valuation for your company. We work hard to make the process easy on you so you can spend more time doing what you do best. Contact us to solve your 409A problems quickly and efficiently.

My company is based outside of the United States, do I need to worry about IRS Section 409A?

Are you looking to hire a U.S. citizen? Are you thinking of opening an office in the U.S.? If you answered yes to either of these questions and are considering issuing deferred compensation (for example stock options or restricted stock units) then IRS Section 409A should be something you consider.

How do I determine fair market value for an 83b election?

If you already know you need to file an 83b election then the first question you probably have is how do I determine the fair market value of the “property” for the election?

There are a few ways to go about determining the fair market value of the shares in your 83b election. If your company is early days, i.e. pre-revenue, pre-investment (arm’s length or otherwise), pre-IP, and has minimal assets on the books, then you might be able to use the par value of the shares for the fair market value (verify this with your lawyer/accountant). However, if your company does not fit these criteria then you will need to calculate the fair market value using the accepted AICPA guidelines.

The three accepted approaches for determining the fair market value of your company are the Asset Approach, the Income Approach, and the Market Approach. After using the appropriate approach to determine the fair market value of your company you will then need to determine the value of your relevant share class. If your company only has one share class of shares then you can divide the enterprise value by the number of common shares and apply any relevant discounts (a discount for lack of marketability for example) to determine the value of your individual shares. If your company has more than one share class then you may need to leverage the option pricing model or an alternative method to determine the value of your individual shares.


I’m Ready To Get a 409A Valuation. What Documents Do I Need to Provide?

You will need to provide a fairly extensive list of documents. But don’t worry if you don’t have them all. We can walk you though exactly what you need quickly and efficiently.

The following is an overview of what you will be expected to provide to fullfill 409A valuation requirements. It is not necessarily an exhaustive list, as other documentation may be required as we work through your valuation. To help get your 409A valuation started right away, it is helpful to get all these documents ready in advance.
Corporate Documents:

  • Articles of Incorporation
  • Company Bylaws

If you have made any changes to your articles of incorporation, such as adding classes of shares, then you will have to provide:

  • Amended and Restated Articles of Incorporation

Company Information:

  • Management Biographies (can be a link to the relevant page of your company website)

If you have had a code 409A valuation performed before, then:

  • All Previous IRC Section 409A Valuations

For all companies, even if you incorporated last week:

  • Year to date Income Statement for the period ending on the valuation date
  • Balance Sheet as of the valuation date
  • Trial balance

If your company has been around for more than a year:

  • 5 years of Income Statements (or since incorporation)
  • 5 years of Balance Sheets (or since incorporation)
  • 5 years of Statements of Cash Flows (or since incorporation)

Companies with meaningful revenues have to provide:

  • 5 years of revenue, expense and tax rate projections

What do I mean by meaningful revenue? Think about it this way: is it possible to imagine using your revenue to value your company? If yes, then get your 5 year projections ready and submit them along with your other documents. If you submit your projections and your private company appraiser doesn’t do a discounted cash flow calculation, then you are no worse off. If you don’t and they want to run the calculation, then it could delay your valuation.

Companies that have subsidiaries which have their own separate accounts:

  • All the above financial information for any subsidiaries

If your company has issued stock options or warrants:

  • A schedule of options and/or warrants

If your company has any outstanding debt (including convertible debt):

  • Debt agreements

Other than the above documents, you will also be asked to provide some information about your company. But it is your company so it is likely no preparation will be required to answer those questions.

Are you ready to start your 409A valuation? Contact us, and one of our appraisers will be in touch and we can get your valuation started.