Certified 409A valuations for US and non-US companies issuing stock options and equity incentives to employees — in compliance with IRS Section 409A and AICPA guidelines.
Windeye Partners frequently performs business valuations for early stage companies that plan to provide options or other equity incentives to employees and need to comply with the US 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, healthcare services, and consumer products. Our clients are primarily US based, but we are also experienced in assisting non-US companies that offer equity incentives to staff in the US and need to comply with the 409A regulations.
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.
The Internal Revenue 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.
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." 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 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; and c) 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." Such a valuation must also be performed by someone with "significant knowledge and experience or training in performing similar valuations."
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.
Our standard 409A valuation process is 10 business days, but in time critical situations this can be shortened to 5 business days if the required information is readily available.
Company formally engages our services and we provide a customized information request list for business, financial and ownership information. We also define what measurement date will be used for the valuation — typically a recent month-end, but in some situations a date 12–36 months back can be used.
Client provides requested information including historical financial statements for 1–5 years, year-to-date financial statements, and existing financial forecasts or projections. We generally request financial projections for 3–5 future years. Documents can be uploaded by client to a secure cloud drive.
We perform an initial review and analysis of the information provided, request additional information and/or clarifications, and schedule a call with company management.
We review and discuss with key management the company's strategy, business, technology, competitors, finances and other important aspects that may have an impact on the valuation.
We perform a valuation analysis of the company total equity value and derive a preliminary value for the common shares or other security that is the subject of the valuation report, in conformance with IRS regulations and AICPA guidance.
Our preliminary valuation conclusion is shared and discussed with the client.
We draft the formal valuation report, incorporating any required adjustments to the preliminary valuation analysis and additional information provided by the client.
Our draft valuation report is shared with the client for a final review.
We issue a final valuation report and value conclusion to the client.
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 directly applicable to a 409A valuation.
For early stage companies that have raised capital in the form of preferred equity or similar instruments the Guideline Venture Funding or "back-solve" method is often required to derive a proper value for common shares. The Guideline Venture Funding method involves estimating the value of the business by taking the price of the latest venture preferred equity investment, or similar funding, and calculating what liquidity event would be required for that preferred equity series to receive its original investment amount, given certain assumptions about the exit event, the company's capital structure, and volatility. An option pricing model using the Black-Scholes formula is used to solve for the implied exit value (see example).
Since we wish to determine the fair market value of one share of common stock, and an early stage company may have several series of preferred stock or other equity instruments, a critical step is to determine how the equity value of the company would be allocated among the different equity instruments given a certain value for 100% of the equity. Several methods for allocating the equity value can be acceptable, each with certain merits and tradeoffs:
As 409A valuations are concerned with the value of one share of common stock — a minority interest — discounts for lack of control and lack of marketability are typically applied relative to a 100% equity interest in the business being valued. For a discussion regarding such discounts see our section on Valuation of Minority Interests.
For further details regarding 409A valuations we recommend that you consult the AICPA Guide Valuation of Privately-Held Company Equity Securities Issued as Compensation.
Foreign companies with a subsidiary and employees in the US are also subject to the 409A regulation. For a discussion about valuation issues in such cases, or for non-US companies that have undertaken an inversion of their structure and reincorporated in the US, please read our white paper. Read More →
For company founders and management the issues surrounding 409A valuations can be confusing. Below are answers to frequently asked questions.
Contact Windeye Partners to learn how we can assist you.