If you’re already familiar with IRC 409A, you probably know that safe harbor 409A valuations are important. But do you know how important they are? Let’s find out. We’ll dive into the details of what a safe harbor 409A valuation means, why it exists, and what’s at stake when you’re found in non-compliance.
Let’s be real: the penalties for 409A non-compliance are insane. That said, they exist for a reason. Enron went and ruined it for everyone. But safe harbor presumptions exist because the penalties are so harsh. It’s a win-win situation. The IRS doesn’t have to go through your 409A valuation with a fine-tooth comb. In return, they don’t tax your employees to kingdom come. They’re giving you an out. You should effectively view safe harbor presumptions as mandatory for completing your 409A. We’re taking a hard stance on this one. Stunning and brave, we know.
409A Safe Harbor Presumptions
IRC 409A has three presumptions through which you can achieve a safe harbor valuation. If you meet the conditions of any of these three presumptions, you’re in the clear; unless your valuation is found to be “grossly unreasonable”, of course. Then again, if you’re tripping the alarm for 409A shenanigans, there’s a good chance you’re up to shenanigans. The three presumptions are as follows:
- The Binding Formula Presumption
- The Illiquid Startup Presumption
- The Independent Appraisal Presumption
Each of these presumptions is complex and unique. Each provides you with a clear path to achieving a safe harbor 409A valuation. Today, we’re going to explore the complexities of these presumptions. Get excited.
The Binding Formula Safe Harbor Presumption
The binding formula presumption applies to 409A valuations based on the consistent use of one, generally-applicable repurchase formula in the company’s stock transfers. The legal verbiage around this is the stuff of nightmares. This formula applies whether those transfers are compensatory or non-compensatory. It’s applied all of a company’s stock transfers and the stock transfers of at least 10% of the company’s shareholders. It’s worth noting, that last part isn’t entirely true. The IRS specifies: any person or issuer holding more than 10% of the combined voting power across all classes of the issuer’s stock. Make of that what you will.
The big exception to the binding formula safe harbor presumption are “arm’s length transactions” related to the company’s stock. These are transactions for which both buyer and seller have no prior relationship and act independently of each other’s interests. The actual legislation covering this safe harbor presumption states that this generally-applicable formula should applies when used as part of a nonlapse restriction surrounding the company’s stock. The Legal Information Institute has more details on how the IRS defines a nonlapse restriction, but that’s far too deep a rabbit hole to jump down here.
The Illiquid Startup Safe Harbor Presumption
The illiquid startup presumption to safe harbor 409A valuations is intended to accommodate the startup environment, where equity switches hands on a much more frequent basis. It applies only when both the service recipient and the service provider (typically the “employer” and “employee”, respectively) do not anticipate an IPO within 180 days or a change of control event within 90 days. A change of control event is what you’d expect it to be. It could be a shift in voting power such that one person or entity holds more than 50%. It could be a liquidation; could be a substantial sale of assets; could be a board call. Point is, you’ll know it when you see it.
Under the illiquid startup presumption, your 409A valuation must be performed by a “qualified individual”. The IRS specifies a qualified individual to be someone companies can reasonably rely upon based on some combination of knowledge, education, training, and experience. They further specify this to mean five years of relevant experience.
Before we move on to the next safe harbor presumption, let’s talk about the term “illiquid stock”. Not exactly a term that comes up in everyday conversation. It refers to the stock of companies with no “material trade or business” and no equity securities traded on an established market. This definition applies both to the startup and any of its predecessors going back a period of ten years. The IRS is effectively outlining the type of company in which that “startup environment” (of equity changing hands left and right) exists.
The Independent Appraisal Safe Harbor Presumption
When it comes to the matter of 409A safe harbor appraisal methods, the independent appraisal presumption is among the most common to pursue. We’ve covered the independent appraisal presumption before. The IRS wants an independent 409A valuation from reputable firm that employs consistent, well-documented methodologies in their appraisals. This is typically the easiest route to take in securing a safe harbor 409A valuation. Find an independent accounting firm and pay them to do your 409A valuation. What’s so hard about that, right? Turns out, finding a quality fully-independent firm is more difficult than it seems.
Many companies turn to their cap table software providers for a 409A valuation package deal. This makes sense. Your cap table software has access to almost all the data you need to perform a safe harbor 409A valuation. However, even the leading cap table software providers push (even cross) the boundaries on independence. It comes down to a conflict of interest, any way you slice it. Your cap table software provider finds a reputable 409A valuations provider; they come to some sort of referral commission agreement; that’s fine. Their arrangement isn’t affected by the outcome of your valuation. But software providers can set up their own “independent” 409A valuation firms. They can also buy existing firms. Some might even have a higher stake in the equity and liquidity of client companies. That’s where you start to run into conflicts of interest. Demanding transparency and simplicity in a software provider’s relationship with a valuation firm will give you a better shot at achieving a safe harbor 409A valuation.
Failing to Achieve a Safe Harbor 409A Valuation
We said that you should view meeting safe harbor requirements as a mandatory part of your 409A valuation. While it’s not actually required, the penalties of non-compliance aren’t worth the risk. Not even close. These penalties are exacted on each employee deferring compensation. They’re hit with a tax on their income, with the entire balance of their deferred compensation plan applied—for the current year and all past years for which their compensation was deferred. There’s a 20% excise tax on that. On top of that, the IRS charges interest on that 20%. That premium interest rate is roughly 1% plus the federal underpayment rate (which is typically under 10%). Employees are hit with these tax penalties in tandem with whatever fees and fines they accrue in their efforts to pay off what they owe. It’s a nightmare. That’s what safe harbor valuations are for.
EquityEffect prides itself on maintaining simple transparent partnerships with reputable valuation firms to offer you your best shot at 409A safe harbor status. Achieving a safe harbor 409A valuation requires an independent firm. That independence is not something many software providers are willing to offer. We are. Check out our blog for more 409A best practices, cap table management tips, and other topics for startups, private companies, VCs, and law firms. You can also request a demo with one of our software specialists. Can’t wait to see what we’ve got to offer? Sign up for free to use EquityEffect today!