409A Valuations: Why You’re at Risk

Here’s the deal. 409A valuations will wreck your employees’ lives and run your business into the ground, in that order, if you do not do them right. We’ll get into why that is—and why you can’t afford to roll the dice on a valuation deal that’s too good to be true—in due time. Because, let’s be clear: you bet on a cheap price tag or a firm that muddies the water on its business ties—if you take that gamble and you lose? It is game over. Period. Failure to comply with Section 409A of the Internal Revenue Code incurs penalties which exist solely because drawing and quartering you would be uncouth. But, let’s start from square one…

Fast Facts on 409A Valuations

• You need to meet IRS criteria for securing a safe-harbor 409A valuation. Failure to do so risks sending all your employees into bankruptcy.
• The most successful route to achieving a safe-harbor valuation is through the services of a third-party firm. Valuation firms must operate independently of your company and any intermediaries (such as your cap table software provider).
  
• Best Practice: Invest in independence and quality when selecting 409A valuation services. If services are packaged into the products of current or prospective software solutions providers, the financial relationship between the two companies should be simple—free of any conflicts of interest.

If your company offers—or plans to offer—stock options to service providers, you are legally required to regularly undergo a 409A valuation.

Let’s unpack that sentence. A “service provider” is exactly what it sounds like; so who provides a service to your company? Employees, executives, board members, contractors; anyone to whom you might offer stock options or appreciation rights in exchange for work. Next, what is a 409A valuation? That requires more depth than a tangential explanation can provide, hence the hyperlink. In a nutshell, it’s an appraisal of the fair market value of your company’s common stock. Assuming you have a basic understanding of what a 409A valuation is, let’s unpack the word “regularly”. “Regularly” can mean (a) every 12 months, or (b) at the end of each new round of funding—whichever comes first.^[1]

The rest of this article is going to focus on the legal requirement of 409A valuations: what’s required, what options do you have, and what’s at stake if you do it wrong?

Technically speaking, you have three options when performing a 409A valuation: (1) do it yourself, (2) do it with software, or (3) hire someone to do it for you. Realistically, you have only one: hire an independent firm. If you’ve already heard about IRC 409A, you’ve probably heard the hubbub about safe-harbor valuations. “Safe-harbor” means meeting a set of circumstances under which the IRS is willing to accept the results of a valuation as legitimate unless they’re believed to be “grossly unreasonable”.^[2] Rarely does the IRS make a win-win scenario crystal clear. They don’t have to deal with your valuation—going through each line with a fine-tooth comb—and you don’t have to deal with them dealing with your valuation. How’s that for a tongue-twister?

Just as there are three routes to completing a 409A valuation, the IRS has outlined three paths to landing a valuation under the umbrella of “safe-harbor” status.

1. The valuation is “based upon an independent appraisal”.^[2]
2. The valuation is based on “a generally applicable repurchase formula”.^[2]
3. The valuation is performed by a “qualified individual” at a time in which the company doesn’t anticipate a change in control or have plans to go public (in the case of startup companies with illiquid stock).^[2]

Two of those paths are loaded with minutiae ripe for missteps; the other is, effectively, “hire an independent firm”. Whether or not you can take a hint is up to you. Of course, assuming you can take the hint doesn’t do much to drive our point home. So, let’s discuss: who qualifies as an independent firm and what do you risk by not turning to them for your 409A valuation?

What Counts as Independent Appraisal?

Any software provider claiming they meet the criteria for safe-harbor valuations or handle valuations “in-house” is lying to you. Plain and simple. For valuations to count as “safe-harbor” under IRS guidelines, 409A firms must provide no additional services to your company. There must be no conflicts of interest between you, the firm handling your 409A valuations, and “middle men” like software providers. When it comes to third-party valuations, when we say “independent”, we generally mean “independent and reputable”. Places like Deloitte or PricewaterhouseCoopers with fancy names and an well-established track record in the professional services industry. Obviously, a reputation for quality comes at a cost. That’s not to say a more affordable provider won’t steer you towards a 409A safe harbor, but an appraisal from “Uncle Bucky’s Valuation Shack” is going to raise some eyebrows at the Department of the Treasury. Point is, there’s a balance to be struck. But more on that later.

409A valuations can also be packaged into another product or service. These packages typically come from tax consultants, HR outsourcing firms, business planners, and software providers—businesses you already trust with your equity data. Be careful with package deals. We can’t stress this enough. The big issue here is “conflict of interest”. In the context of 409A valuations, this refers to an economic benefit which might affect the outcome of the appraisal.^[3] Package deals are an easy way to obfuscate economic benefits and give the IRS a reason to call the independence of your appraisal into question. The firm chosen to perform your 409A valuation should not be providing your company with any additional services.^[3] If your provider handles their valuations in-house, that’s a conflict of interest. If your provider partners with a firm specializing in 409A valuations, you must demand transparency regarding the nature of their partnership. As a rule of thumb, the relationship between these companies should be simple. “We get a 10% commission on all the valuations we send them.” That’s where the relationship should start and end. Before investing in a package deal, you need to make sure there is no shared ownership or equity between the two firms. Anything that muddies the waters of a truly independent appraisal jeopardizes your path to safe-harbor protections.

Cruel and Unusual Punishment

If you pay for and submit a 409A valuation to the IRS which does not meet the criteria for safe-harbor, you risk sending all of your employs into bankruptcy. Let’s talk about what this looks like.

You know the risks of not turning to an independent firm for your 409A valuations are bad when the list of consequences starts with an audit. Before we list the rest, let’s establish how you got here. You could have gone the DIY route or invested in software marketed as being the “one-stop DIY solution” (we’ll link directly to them—good luck and godspeed). You could also have, intentionally or otherwise, opted for an evaluation that wasn’t as “independent” as they first made themselves out to be (see above). Regardless of how you got here, you’re here. Now you’re staring down the business end of Caligula’s thumb. Thumb goes up? Crisis averted. Thumb goes down? Game over. Here’s what that entails for each option holder.

• Ordinary Income Tax: Option holders are taxed based on ordinary income tax rate multiplied by the sum of the per share value at which the options were granted subtracted from the IRS’ assessment of your company’s current fair market value (per share).^[2] This means an employee holding 5,000 shares granted at $3 per share in a company the IRS has determined to currently be worth $45 per share would, at an ordinary income tax rate at 39%, owe an additional $81,900 in taxes that year.

• 20 Tax Penalty: On top of the above, an additional 20% tax penalty is incurred. The employee, in our example scenario, would now owe a total of $98,280.^[2]
• Accrued Interest: On top of the massive excise tax and 20% penalty, employees are charged for interest on underpayments towards the full amount owed.^[2]

This fails to account for the smorgasbord of other fees option holders may rack up in their attempt to pay off what they owe. Worse yet, this vicious penalty is incurred each time the options are vested. If your employees haven’t jumped ship by then, congratulations on your cult. Of course, the IRS has instituted certain leniencies—including a 409A Correction Program—to prevent innocent employees and well-meaning companies from suffering unjustly. However, the catastrophic damage 409A violations can do to your business is clear.

Finding the Balance

As we’ve said: there’s a balance to be struck between the quality and reputation of an independent third-party firm and what they charge for a 409A valuation. There’s no prescriptive advice we can offer in selecting a 409A valuation provider without knowing your budget. You need to comfortably and unquestionably secure a safe-harbor valuation. That’s your baseline. It’s not something you can afford to sacrifice or compromise. Assuming you don’t have the budget to spring for the heavy-hitters (your Ernst & Youngs; your KPMGs, etc.), let’s talk about what you can do to narrow down your list.

• Reviews: Turning to trusted review sites that can’t be bought out or manipulated is a great way to filter the pretenders from your contenders. Make sure you take the time to read the reviews, keeping an eye out for red flags.

• Clientele: You might not see any big names—any recognizable names, for that matter—from a firm’s portfolio of clients. That’s not necessarily a deal-breaker. Make sure the companies the firm you’re considering serves are healthy, growing operations; effectively, suss out whether they can afford not to farm their appraisals out to the lowest bidder.
• Transparency: The firm you choose needs to operate independently. That’s the bottom line. But there’s a lot that can be done, especially in package deals, to cloud or conceal a conflict of interest. If you’re questioning a firm’s independence (which alone, may be enough to disqualify it from consideration), don’t be afraid to press them on it. If they’ve got nothing to hide, there should be nothing standing in the way of full transparency.

Want a quick-and-dirty guide for choosing a 409A valuation firm? They need to pass your smell test. But, to do that, you’ll need to sniff around a bit. Do your homework. With all that’s at stake, you can’t afford to leave stones unturned.

The Wrap-Up

Fugu is a pufferfish popularly enjoyed in Asian cuisine. You can try it fried, smoked, stewed, or in a delicious sashimi. Fugu is rich in tetrodotoxin—a nerve agent which paralyzes the lungs, causing death by asphyxiation in under an hour. Because of this risk, chefs specializing in preparing fugu will train for seven to ten years. Refusing to employ an independent firm when appraising the fair market value of your common stock is “budget fugu”. You’re welcome to do so, but do you want to?

We hope we’ve left you with an idea of the options available to you when searching for an independent 409A valuation and what’s at stake when that search leads you down the wrong path. Check out our blog for more information on 409A valuations. If you’re looking for a cap table management software provider with a fully-transparent, fully-independent partnership with a trusted valuation firm, look no further. EquityEffect is an all-in-one platform for everyone with a hand in your equity. We’re a portfolio manager for venture capital groups, a cap table manager for private companies, and an equity management tool for law firms. EquityEffect isn’t just your home base. We’re everyone’s home base!

References

1. Eyman, Dan. “Why Independence Matters – 409A Valuations & Safe Harbor.” Meld Valuation, meldvaluation.com/blog/compliance/why-independence-matters-409A-valuations-safe-harbor/
2. Kim, Larry. “7 Things You Need to Know About 409A Valuation.” Inc., www.inc.com/larry-kim/7-things-you-need-to-know-about-409A-valuation.html
3. United States. Internal Revenue Service. “Internal Revenue Bulletin: 2007-19.” Internal Revenue Bulletin, no. 19, https://www.irs.gov/irb/2007-19_IRB. Accessed 20 May 2019.