The Human Capitalist Series P.8: Q&A on Section 409A Valuations

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The Human Capitalist Series P.8: Q&A on Section 409A Valuations

What is the purpose of Section 409A?

Internal Code Section 409A attempts to limit and regulate the use of “deferred compensation”—that is, the legally binding right to receive compensation in a future year, after it is no longer subject to a substantial risk of being forfeited by the recipient. The IRS has created a special exception from the application of Section 409A for stock options, but only if the options are (1) priced at not less than the fair market value on the date of grant and (2) do not contain “deferral” features (e.g., liquidation preferences or put/call rights above fair market value).

Regarding option pricing, the IRS doesn’t want companies playing games with how they set fair market value. So Section 409A has very clearly defined rules on how to measure fair market value for both public and privately held companies.

Why do I need a 409A valuation? Can’t I just use some discount to the last round price or have our CFO just come up with a value?

To avoid adverse penalties under Section 409A, the exercise price per share of stock options must be equal to or greater than the fair market value of the company’s common stock as of the date of grant, as determined by the company’s board of directors. The tax code provides a “safe harbor” to determine the fair market value—that is, the board must determine fair market value based on a valid (i.e., recent) 409A valuation from a qualified independent third-party valuation firm. The board will not get the benefit of the IRS “safe harbor” if it determines the fair market value by another method—e.g., a discount to the last preferred round, a two-page report written by a CPA or CFO, or the dot.com era “rule of thumb” (e.g., 1/10th of the preferred price).

To satisfy the safe harbor, the valuation report must be:

  • Not more than 12 months old (from the date of the valuation—not the date the report is received by the issuer); AND
  • Reflect all material information known to the board at the time the board is determining fair market value.

This means that, at a minimum, the company may not rely on a valuation report for more than 12 months. Further, if the company has entered into or is in active conversations regarding a material transaction, or some other material event occurs, the 409A valuation may go “stale” and need to be updated before the 12 months are up.

In such a case, the board should consult with counsel on whether to wait to grant additional options until a new valuation can be obtained or whether to rely on an alternative to traditional stock options to compensate employees who are expecting options. Alternatives include using restricted stock, fixed-date-exercise options, restricted stock units, and cash-based deal bonuses.

What are some examples of “material” transactions or events that could change the company’s valuation and therefore require a new 409A valuation?

As mentioned above, a company needs a new 409A valuation if the company has entered into or is in active conversations regarding a material transaction or if some other material event occurs. The overriding presumption is that the value of the company’s common stock changes immediately upon the occurrence of any material transaction or event, and thus a new 409A valuation would likely be needed. Here are some examples of what we mean by that:

  • Signing a term sheet for or closing a material capital raise (equity, SAFE, debt, etc.);
  • Receiving a term sheet for an acquisition (unsolicited or solicited);
  • Launching a new product;
  • Executing a material contract;
  • Making material changes in a revenue forecast or other operational metrics (e.g., Daily Active Users);
  • Obtaining a major customer;
  • Completing secondary sale transactions, in some cases;
  • Closing a strategic transaction (e.g., acquisition, joint venture); or
  • Any other change to the assumptions on which the valuation firm relied in drafting the previous 409A report.

Note that even rejected offers or abandoned transactions can be material enough to move the needle. When in doubt, ask your outside counsel or 409A valuation provider whether an intervening event is material enough to require a new valuation.

What happens if the board is not relying on a third-party “safe harbor” valuation to determine fair market value?

If the board does not rely on a recent third-party valuation report that reflects all material information known to the board at the time option grants are approved, the recipients of the options granted are at risk of significant Section 409A penalties.

That is, if a stock option is determined to have been granted at a discount, or otherwise violates the Section 409A rules applicable to stock options, the optionee will owe income taxes plus a 20% penalty (plus, in California, a 5% penalty) on the full spread on the vested portion of the option each year that it remains unvested. In other words, the employee will owe significant amounts each year in taxes and penalties even though the employee has not exercised the option and has no liquidity to pay the taxes and penalties. And the company has an obligation to withhold these amounts and report the failure to the IRS on the optionee’s W-2 or 1099.

Investors and acquirers are particularly concerned about discounted options, because the taxes and penalties can be in excess of the spread on the option by the time the employee exercises. Companies face significant costs (i.e., money, time, employee morale, bad publicity, cheap stock charges, FAS 5 liabilities) in addressing discounted options after the year of grant. In some cases, there is no solution to a discounted option other than paying the penalties to the IRS. Therefore, many investors and acquirers will require the company to undertake remedial action or may impose a significant transaction cost on the company if the investors or acquirers believe that there is a material risk under Section 409A.

Also, with respect to FAS 5 (mentioned above), discounted options result in deferred tax liabilities on the company’s balance sheet. If this liability isn’t properly accounted for, it may come up during a future audit of the company’s financial statements and result in a costly and time-consuming revision or restatement of the balance sheet. If this occurs in tandem with a sale of the company, venture capital (VC) financing, or an initial public offering (IPO), it could delay or derail the entire deal process.

Companies should consider future transaction costs (including deal risk and potentially million-dollar indemnification obligations) when considering the relative cost of a third-party 409A valuation.

Won’t our investors think our enterprise value is too low if we obtain a third-party valuation, rather than using the post-money financing value?

Most savvy investors understand that a 409A valuation report is prepared using rules established under the tax code—not traditional venture financing valuation methodologies—and is used purely for the purpose of administering a stock plan, not for other business or financing purposes. For example, a 409A valuation will discount the enterprise value of the company from the last post-money deal valuation to reflect the preferences given to the preferred stock on liquidation and discounts for lack of marketability and control. Most savvy investors want to see that a company they invest in is following the safe harbor rules for Section 409A, because that indicates the company has a sophisticated management team that is actively managing risks involved in granting employee equity.

How much does a 409A valuation cost?

We certainly see a range of fees quoted for 409A valuations. Factors that impact price include the experience level of the valuation expert, the turnaround time, and the complexity of the cap table.

For small startups with very simple cap tables, one would expect a valuation to cost less than $5,000. Carta and Shareworks both include free or low-cost 409A reports as part of some of their subscriptions. Many early-stage companies use Carta and Shareworks for this reason.

For companies with sophisticated cap tables (e.g., multiple classes of preferred, debt instruments), with unusual fact patterns (e.g., newly founded and already generating significant revenue), or with more than a few secondary transactions in their stock, one might see a valuation cost running from $10,000 to $25,000.

Companies looking to investigate their alternatives should consider Scalar, Oxford Valuation Partners, Redwood Valuation, and Teknos Associates.

I think we have offers from our partners (banks, VCs, etc.) to get a 409A valuation for free. Can’t I just use the free valuation?

We haven’t heard of banks or VCs offering truly “free” 409A valuations. It may be that they’re offering to introduce you to their partner firms that would provide one or that it is part of some other business service for which you are already paying money. They may also be thinking of valuation firms looking to enter the 409A space that do not have a strong existing background working with venture-backed companies (and therefore may come up with a valuation that is inconsistent with a valuation that might be rendered by a valuation firm with a decade of experience valuing venture-backed companies).

While cost isn’t necessarily indicative of quality, the cost generally does reflect the required level of professional expertise to prepare a “safe harbor” valuation. An issuer should carefully investigate the credentials of the valuation expert providing the free or low-cost valuation report, including the number of valuations done under Section 409A each year for venture-backed companies, the number of valuations done that have withstood audit by a Big Four accounting firm, and the number of such valuations that have withstood cheap stock charges by the Securities and Exchange Commission at the time of an IPO.

We are about to hire an employee and we are promising her options. Do we need to get the 409A valuation before she can sign her employment contract?

No. A promise to grant options in an offer letter is not the actual grant of the option. The board will need the valuation on the date the options are actually granted, which is typically done at the next board meeting or at some regular interval.

Please note that your offer letters should never specify the price per share for option grants or promise that it will be granted by a specific date. As noted above, the valuation needs to be effective on the date of grant—and much can change between the date of an offer letter and the date the board meets to make option grants. The offer should simply say “at the fair market value to be determined by the board of directors on the grant date.”

If you are offering a share percentage rather than a specific number of shares, the offer letter should also clarify when the percentage of shares is measured, and how specifically it’s calculated—e.g., “0.04% of the company’s outstanding shares on a fully diluted basis, as calculated on the grant date” or “0.04% of the company’s outstanding shares on a fully diluted basis as of the date of this letter, which is [#] shares.”

Our last 409A report was dated 11 months ago. Are there risks to using that report?

Yes. As noted above, the board’s determination of fair market value on the date of grant must reflect all information known to the board on that date.

Note also that many reports determine fair market value as of December 31. Companies should be very careful granting stock options in the last month or two of a calendar year, given that Section 409A severely limits the ability to fix option discounts after the calendar year of grant. Consider delaying option grants until January of the following year.

For example, if an option is granted on December 15, 2021, in reliance on the valuation dated December 31, 2020, which determined the fair market value to be $1.50 per share, the company may not realize the risk of using that valuation until 2022, when the new valuation report for December 31, 2021, is received and comes in at $2.00 per share. The stock price does not go up overnight by $0.50, absent some material intervening event. Therefore, the optionee is at risk that an investor, an acquirer, or the IRS will question the validity of the underlying valuation report and impose penalties or other consequences. At that point, it may be too late to fix the option pricing in a cost-effective manner and without significant employee relations issues.

Our last 409A report was dated three months ago. We are about to get a term sheet. Are there risks to using our report?

Yes. As noted above, the board’s determination of fair market value on the date of grant must reflect all information known to the board on that date. If the prior valuation did not anticipate a term sheet, or if the term sheet that is received materially differs from the anticipated term sheet terms shared with the valuation firm when it drafted the valuation report, discuss the risks of using that valuation with legal counsel prior to making any option grants.

Do we need to get a new 409A valuation if we are not granting options but need to determine fair market value to report the spread on the exercise of existing options or the repurchase price for unvested shares?

The 409A “safe harbor” applies only to the determination of fair market value for purposes of granting stock options. The determination of fair market value for purposes of exercising a stock option is determined under a different tax code section. That said, a 409A valuation is generally a reasonable basis to determine fair market value for purposes of determining the spread on exercise. Companies should avoid using one price for determining the spread at exercise and a different price for purposes of granting stock options.

If a company is concerned about using an older 409A valuation for other purposes, or has not previously obtained a 409A valuation, consider contacting legal counsel to determine alternatives.