THE ULTIMATE GUIDE to 409A Valuations
What is a 409A plan?
In a broad sense, a nonqualified deferred compensation plan refers to compensation that the company promises to pay to its participants in a subsequent plan year. Essentially, workers earn a sum of money in one year and they get paid at some time in the future. A 409A plan sets a “strike price,” which is the price that employees can buy equity in the company. The “strike price” must be set at or above fair market value.
This nonqualified deferred compensation is different from deferred compensation that comes from qualified plans like 401(k) plans, 403(b) plans, and 457(b) plans.
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The History of IRC 409A
While Section 409A of the IRC has been around since the 1980’s, it’s current iteration was developed in the wake of the Enron scandal. Before Enron went bankrupt in the early 2000’s, a number of employees accelerated payments from their deferred compensation plans. They received millions of dollars ahead before the company’s stock price plunged, leaving thousands of employees with only a small fraction of their retirement savings. With the passing of the American Jobs Creation Act in 2004, the IRS went beyond simply closing the loopholes in Section 409A. They had constructed the intimidating, nearly-airtight legislation surrounding non-qualified deferred compensation we know today.
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Requirements of a Safe-Harbor 409A Valuation
In trying to impart an overview of what IRC 409A is and how 409A valuations work, it’s not worth focusing on anything other than the requirements of a “safe-harbor” valuation. Safe-harbor 409A valuations employ a set of presumptions, as outlined in the Internal Revenue Code, for which the IRS must accept the outcomes of fair market value appraisals unless it can prove them to be “grossly unreasonable”. Failing to meet the qualifications of a safe-harbor 409A valuation exposes your company and its employees to the nightmarish risks of non-compliance penalties.
The three presumptions for achieving a safe-harbor valuation are as follows: your valuation must base itself on (a) an appraisal from an independent third-party valuation firm, (b) a generally applicable buyback or “repurchase” formula, or (c) valuations performed by a qualified individual or company at time in which neither the service recipient nor the provider anticipated an IPO or “change of control” event. The third presumption applies only to the illiquid stock of startup corporations. For those interested in learning more, it’s worth noting: the depth of information and minutiae associated with each of these presumptions is bottomless. In fear of falling down a tangential rabbithole in the middle of our overview, we’ll need to move on.
There are, in theory, three paths to achieving a safe-harbor valuation. You can submit your own appraisal with the help of DIY software. This is almost universally considered to be a bad idea. You can also simply do it yourself, provided you meet the IRS definition of a “qualified individual”. It’s not impossible to achieve a 409A valuation by going this route. It’s just substantially riskier and you’ll have no one to blame should you be slapped with non-compliance penalties. The third path to securing a safe-harbor valuation, employing the services of an independent third-party valuation firm, is widely believed to be the safest and most successful option.
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409A Regulations and Compliance
Want to learn how to avoid 409A penalties? Good, you’re in the right place!
Nothing jeopardizes the stability of your growing company like having the IRS down your throat. But if your company doesn’t comply with Section 409A of the Internal Revenue Code, that’s exactly where they’ll be. The IRS doesn’t mess around when it comes to 409A non-compliance. You have Enron to thank for that. If you offer non-qualified deferred compensation to your employees, you should be justifiably paranoid about your 409A.
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How to Create a 409a Compensation Plan
While companies focus heavily on the fundamentals of running their business, they also need to have a comprehensive understanding of how to create an employee stock option plan correctly. From creating the plan to managing it, there are many details to address and monitor. Any missteps during these processes will almost certainly create serious problems for the founders and their board.
Companies that violate regulations for employee stock options can face fines and legal exposure. Financial problems and inconsistencies could delay an IPO or acquisition. If mistakes affect your employees’ grants, it will upset them and cause them to lose faith in your company.
You’ll need to rely heavily on your legal team when you offer employee stock options. While lawyers will take care of any legal tasks, you still bear the responsibility of informing them when your hiring plan changes or when you make an offer to a new employee. They won’t have the right information to help you if you don’t keep them informed.
It’s not overly complicated to create an employee stock option plan when you have the right tools. Take the process a step at a time to ensure that you’ve covered all of your bases.
Creating an employee stock option plan requires an upfront investment in time and expense, but it can cost substantially more later if you get it wrong.
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409a Valuation Methods
The purpose of a 409A valuation is to determine the value of the shares that your privately held company can offer to your employees in the form of stock options on a tax-free basis. It’s imperative to be diligent in getting an accurate, thorough 409A valuation for the benefit of your company and to avoid having issues with the IRS.
You’ll need to allow for sufficient time to gather the essential data and materials together and complete the valuation. If you choose to hire a firm to do your valuation, it’s crucial to contract with a qualified firm with a good reputation to avoid penalties.
In this article, you’ll learn about what data you need for a 409a valuation, how to choose a valuation firm, and the 409a valuation methods you can use to avoid having issues with the IRS.
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Navigating 409A Prices and Providers
Every new venture starts with a dream. If you are a budding entrepreneur whose dream it is to start an innovative company, the road to making that dream a reality is loaded with twists and turns. Like signposts on a real highway, you’ll rely on myriad useful (and necessary) information to guide your journey and mark its progress. Think of a 409A valuation as a major milestone on your road towards the operational launch of your startup. In this article, we’ll explore the range of 409A valuation costs, what you get for your money, and how to choose the right provider.