What is it? Simply put a 409A valuation is an independent figure that captures the fair market value (FMV) of your company’s stock price.
It only applies for private companies, as public companies have listed stock prices that are captured on a daily basis on the world’s stock exchanges.
A 409A valuation is important for both companies and for employees as it captures the tax liabilities for those who hold equity. As most employee stock options are regarded as deferred compensation, it’s impossible to accurately calculate the correct rate of applicable tax without a valuation. As such, it should be the corner-stone of your yearly compliance responsibilities.
Failure to complete 409A or having one that isn’t accurate will have the potential to attract substantial fines from the IRS, so it’s important to get it right.
Importantly, it isn’t something that can be done once and then forgotten about. If you issue employee stock, you must complete a new one every twelve months, or immediately if your company closes a new funding round.
The bottom line? If you don’t do this properly, your employees may be forced to pay the taxes that they owed, an IRS tax underpayment penalty and the accrued interest on unpaid taxes.
In terms of your company’s future, the possibility of an audit becomes more likely when you become successful, and if you’re going to go public the Securities and Exchange Commission are liable to forensically scrutinize pre-IPO stock awards.
How do you come up with a figure?
There are several approaches to deriving your FMV, however, the following three approaches are the most widespread to find the base levels of data that will begin the process.
- Income approach
Free cash flow analysis and forecasting can outline projections for the next five years.
- Market approach
Understanding where your competitors in the market are will allow you to provide a FMV based on comparable private and public companies through their balance sheets.
- Asset approach
The easiest approach as it underpins your yearly accounts, an analysis of a company's tangible and intangible assets can give you a figure that captures your FMV.
Once you have finished your analysis, you are presented with three possibilities to generate a 409A valuation report:
- Self Calculated
Based on the information that you’ve gained you can generate a figure that you believe captures the FMV of your companies worth.
The onus is on you to accurately reflect what you believe the price to be, and as the IRS states that "reasonable application of a reasonable valuation method" is the key criteria that underpin a FMV calculation. However, as we’ve outlined, you need to be able to stand over this figure when an audit arrives. Is it worth the risk?
There are a number of software packages that have been designed as a plug and play option for FMV calculation. However, like doing it yourself the possibility that errors may occur are more likely. More importantly, there is no safe-harbor protection that arises when you engage a specialist.
- Hire a firm
Engaging a firm for a 409A presents the least risky option because of the benefit associated with safe harbor protection. Not only do you get to leverage the experience of people who do this day in and day out, but you’re also giving yourself the protection that exists in using an external party.
More importantly, if a dispute arises with the IRS, hiring an external firm means that the IRS must show that your valuation is too low, as opposed to you having to justify it.
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