Employees are a company’s greatest asset. A business cannot succeed without a team of a competent, driven workforce. However, retaining motivated, target-driven talent can be challenging, especially in a tight labor market.
Savvy business owners strive to create a culture of ownership by aligning the interests of employees with management and investors. A culture of ownership facilitates a healthy business environment where all employees feel equally accountable for their performance and are motivated to do their best, even when not monitored. This is not an easy feat. In the company’s growth phase, business owners often have limited access to capital and need to conserve their capital spending until the company becomes cash-flow rich.
Business owners may grant equity rights to employees to make them feel valued, not just as workers but also as co-owners. Employees appreciate the opportunity to acquire an equity stake in the hope that that stake will yield significant returns one day. This shift in employee mindset facilitates a culture of ownership; after all, if you are an owner, you are willing to take additional responsibility and increase your work output.
Issuing stock options is the most common way of offering equity ownership to employees. With that stock option, the employee can buy a fixed number of company shares over a set period of time at a fixed price. The IRS considers stock options as part of employee compensation.
This is why a 409A valuation is needed.
409A Valuation Explained
U.S. Code § 409A applies to compensation that employees earn in a year. However, compensation paid later in the future is also known as deferred compensation. Stock options fall under deferred compensation.
409A valuation helps find the price at which the employees may buy equity in a business. The price must, however, be equivalent to or above market value. A 409A valuation finds the business’s fair market value (FMV).
This value is usually determined by a third-party valuation service, not the owner or the company. Although the IRS regulates 409A valuation, the idea is to set the strike price for the shares awarded to the advisory team members, employees, and others. 409A valuation ensures representation of the company’s actual value.
While other valuation approaches are directed towards the owner’s exit plan and the need for business valuation, 409A valuation is only done when the business has to offer stock options as a part of equity compensation to employees, contractors, or investors. Section 409A refers to employees’ stock option disbursement rules under the U.S. tax law.
Scheduling a 409A Valuation
There’s no prescribed time to get a 409A valuation; however, the following triggers indicate when and why one is needed, perhaps urgently:
- The business owner decides to offer stock options to employees.
- The validity of 409A valuation: e.g., it has been a year since you had a 409A valuation done.
- The business owners are trying to raise funding or have raised funding.
- When people begin to trade (either buy or sell) company shares, this trading does not include the claims that the business owner had issued originally.
In any of the above cases, you need a 409A valuation performed to avoid IRS penalties.
Importance of 409A Valuation
A 409A valuation is essential for the following reasons:
- With 409A valuation enables business owners to set a fair market value on their company shares and get safe harbor protection.
- Employees can protect themselves from future tax-related issues.
- The business owner and the company are protected against the financial implications from lawsuits or tax liabilities.
- Both the company’s management and investors can gauge the business’s financial standing.
How to Get a 409A Valuation
Business owners can get a 409A valuation in three ways:
Do It Yourself
This is the riskiest of the three options because safe harbor protection only covers 409A valuations performed by qualified, independent appraisers. A business owner performing a DIY 409A valuation must prove to the IRS that it’s correct and that the employees have paid a fair price for their stocks in the business.
To understand this better, suppose an employee can purchase 2,000 shares in the company at $3 per share and the grant period is five years, which means they can purchase these stocks up to five years after their grant date. If the employee decides to take advantage of this offer at a future date when the cost is $6 per share, they would still be paying $6,000 instead of $12,000.
Although business owners might save money by performing the valuation themselves, they are more prone to mistake unless they have relevant expertise and education. The best option is to leave the valuation to professional appraisers.
- Business owners can save time and money.
- They have more control of the company valuation.
- Business owners do not have safe harbor protection if something goes wrong.
- The owners need in-depth knowledge, education, and experience in business valuation.
This option best suits early-stage startups. You might save time and money by using software, but there is no safe harbor protection if you mistake entering data.
- Save time and money. You don’t have to wait for long to receive the report, nor is the expense of hiring a professional valuator incurred.
- You get a generalized estimate of the company value.
- Only suitable for early-stage startups, as there is limited data to evaluate.
- The IRS does not confer safe harbor options to the business owner.
- Not everyone is comfortable using software for valuation.
Hire a Professional
The best and most reliable option to conduct a 409A valuation is to hire a qualified, independent appraiser. This option comes with safe harbor rule protection, which means “The IRS doesn’t have to go through your 409A valuation with a fine-tooth comb. In return, they don’t tax your employees to kingdom come.” Moreover, you need not provide proof if the IRS happens to conduct an audit of your business.
- The valuation is defendable as performed by qualified, experienced appraisers.
- Business owners have safe harbor protection.
- The accurate valuation enables you to gauge the company’s financial standing.
- A qualified, independent professional appraisal is expensive and may take more time than anticipated.
IRS penalties for 409A non-compliance are severe. The idea behind the 409A valuation is to protect the business if there is an audit later. A professional 409A valuation protects employees against those penalties.
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