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409A Valuations

Windeye Partners frequently performs business valuations for early stage companies that plan to provide option or stock incentives to employees and need to comply with the U.S. tax code (i.e. Section 409A) and related AICPA rules. Our experience includes providing valuations for companies in sectors such as software, information technology, biotechnology, medical devices and healthcare services. To receive an example of a 409A Valuation report please email us at windeye@windeyepartners.com or contact Certified Valuation Analyst Michael Guthammar on telephone (929) 223-2935.

409A Valuation Primer

The Internal Revenues Service's code section 409A regulates the taxation of “non-qualified deferred compensation” for employees of all US companies, including the issuance of non-qualified stock options and stock appreciation rights. Non-qualified deferred compensation plans do not include Incentive Stock Options, 401(k) and similar “qualified” plans.

If non-qualified stock options or similar instruments are issued with a strike price that is below the fair market value at the time of issuance, then the difference between the strike price and fair market value will be taxable income for the recipient. In addition, tax penalties (20%) may apply if some time has passed since the stock options were granted. Therefore a private company should always perform a valuation in order to demonstrate that the strike price is at or above fair market value at the time of issuance (for a public company the stock market provides the value).

According to the IRS “fair market value may be determined through the reasonable application of a reasonable valuation method”. Fair market value is defined by IRS Revenue Ruling 59-60 as: “the price at which the subject equity ownership would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is under no compulsion to sell, both parties having reasonable knowledge of relevant facts”. An independent appraisal will be presumed reasonable if “the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.” A company can rely on the valuation report for 12 months from the valuation date, unless there is a material change such as a financing sooner than that.

Overall the IRS counsels that a 409A valuation should consider the following aspects:
• The value of tangible and intangible assets (Asset Approach)
• The present value of future cash flows (Income Approach)
• The market value of comparable businesses, both public and private (Market Approach)
• Other relevant factors such as control premiums or discounts for lack of marketability

The IRS has defined special rules for “start-up” companies with respect to 409A valuations. Start-up companies are defined as companies a) that have been in business for less than 10 years; b) that do not have publicly traded equity securities; c) and for which no change of control event or public offering is reasonably anticipated to occur in the next twelve months. For start-up companies, a valuation will be presumed reasonable if “made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.” Also, such a valuation must be performed by someone with “significant knowledge and experience or training in performing similar valuations.”

Thus a board member or an employee of an early stage company may be able to perform a 409A valuation for that company. However, in most situations this will not be the case and the company will seek an independent valuation from an external provider.

The IRS provides a 12-month safe harbor period for a 409A valuation with respect to the strike price for option grants. After 12 months, or when a "material event" such as a financing occurs a new valuation will be required.

409A Valuation Issues

A valuation for 409A purposes will consider the normal Asset, Income and Market approaches similar to other business valuations. However, early stage companies needing a valuation for this purpose often face particular issues since they may have negative earnings and cash flow, and since post-money valuations from capital raisings are not always dirctly applicable to a 409A valuation. Read More →