You’ve just recruited the first executive for your startup: a hotshot CIO. Naturally, you couldn’t offer her a big salary, but she’ll be the first recruit to receive company stock options. You had been thinking about using stock options and had spontaneously pitched them as being generous enough to send her kids to Harvard. But now the company’s outside lawyer is saying you have to redo the valuation you set during fundraising or those stock options will find your new CIO in hot water. Let’s explore what the esteemed esquire is talking about and what you should have known before offering stock options.
You can thank the fine folks at Enron for Section 409A of the Internal Revenue Code. IRC 409A establishes regulations surrounding non-qualified deferred compensation. In practice, the legislation details how and when to independently determine a private company’s fair market value (FMV). That FMV is the basis for any value of the stock options and appreciation rights you’ve issued to investors, employees, advisors, and so forth. More specifically, it dictates the minimum strike price you can set for the stock options you’ve just dangled in front of your new CIO.
In 2009, the IRS finalized the modern iteration of Section 409A to close the stock compensation loopholes that Enron executives exploited as the company went down in flames. The rule exacts harsh penalties upon recipients of stock options who cash in on too low a strike price. Thankfully, IRC 409A provides a series of “safe harbor presumptions“—in which a 409A valuation is presumed to be conducted in good faith unless the IRS can prove it to be grossly unreasonable—to help companies avoid the penalties.
A 409A Valuation for Your Startup
- Section 409A applies to non-qualified deferred compensation, such as stock options and stock appreciation rights (SARs).
- The independent appraisal presumption establishes the need for private companies to use an independently-derived FMV on which to base the strike price for deferred compensation. Obviously, a publicly-traded company can simply refer to its stock price on the exchange or its recent OTC price.
- The strike price (the price at which the you execute options and SARs) must be at least equal to the fair market value of the company’s stock as of the options’ grant date.
- A 409A valuation is good for 12 months or until an event occurs that materially affects company value, generally whichever is sooner. Qualified financing is the most common material event for startups—the sale of equity at arm’s length to independent investors. Others material events include issuance of a patent, going public, and resolution of material litigation. A “change-of-control” event or the issuance of new shares can also merit a new valuation.
- The penalties for failure to meet the 409A safe harbor requirements falls mainly on recipients of non-qualified deferred compensation, not the employer. Those penalties are stiff, to say the least.
- Companies require a 409A valuation before it issues its first stock options.
Reasonable FMV in 409A Valuations
A reasonable fair market value is based on a number of factors, including:
- The value of the corporation’s assets (tangible and intangible),
- The present value of anticipated future cash flows,
- The equity value of similar businesses,
- Recent arms-length stock transactions, and
- Control premiums that affect the stock value.
In the end, whether or not a fair market value is reasonable rests on the facts and circumstances surrounding the assessment. For more on this, check out our article on the independent appraisal and binding formula safe harbor presumptions.
409A Safe Harbor: Illiquid Stock Presumption
This may shock you, but the illiquid startup presumption applies only to the illiquid stock of startup corporations. This presumption states that, at the time a “qualified person” determines a company’s fair market value, neither the service provider nor recipient anticipated a “change-of-control event”, such as an IPO, merger, or acquisition. More specifically, an initial public offering cannot be reasonably anticipated within 180 days and a change of control event cannot be expected to occur within 90 days following the enactment of the valuation.
The illiquid stock presumption recognizes that the sudden appearance of a bigfooting investor or a takeover offer will materially affect the stock’s value. Because the stock doesn’t trade publicly, there is no public gauge of the impact of a change-of-control event. That’s why you need a new 409A valuation for your startup. That new valuation must be a “good faith effort”, i.e., not ignoring information that affects the price of the company’s illiquid shares.
A control premium is a stock price above fair market value resulting from the transfer—or attempted transfer—of control within a corporation. For a hot startup experiencing significant growth, their stock’s FMV should reflect the premium an investor or entity would pay to gain control of the company. Clearly, the company’s owners will require a large premium to give up control of a high-growth company with strong prospects. This applies whether the control transfers as a result of a large investment, a buyout, or an initial public offering. The size of the premium also hinges on ways that new ownership can enhance the value of the business.
In part, the illiquid stock presumption exists because:
- A change-of-control event will undoubtedly affect a company’s FMV. In fact, the impact should be considerably larger than that of an equal investment which did not cause a change in control.
- A change of control within a private startup cannot be publicly gauged, since the illiquid shares do not trade publicly.
It makes sense, then, why a new 409A valuation would be mandatory if a change of control is on the horizon. Moreover, if such a change is on the horizon but held secretly, the third-party provider of the 409A valuation will be missing material information that results in an inaccurate estimate of fair market value. In this case, the company would not meet the requirements for achieving a safe harbor 409A valuation. That said, an IPO, acquisition, or merger require new external audits, so the chances of private companies abusing the illiquid stock presumption are often slim.
Risks of Improper 409A Valuations
So often, when a company fails to achieve a safe harbor appraisal, it is because their valuation was not performed by an independent firm. In some cases, this is the result of companies trying to pull the wool over the government’s eyes. However, this typically occurs when a company fails to investigate the independence of their 409A valuation provider. Many companies opt to arrange 409A valuations through their cap table software provider. However, even many leading software providers jeopardize the independence of the valuations offered.
What sort of things could trip up the independence of the 409a valuation provider?
- Hide the salami: colluding with the cap table software provider to ignore or understate the prospects for upcoming change-of-control events.
- Crossing the streams: when software providers start or buy their own 409A valuation firm, using vague or obscured language to make it appear “independent”.
- Payola: when 409A valuations providers, working directly with startups, position themselves to benefit from the outcome of the appraisal.
By cutting corners with the independence of your appraisal, your vessel may capsize before you reach safe harbor. No one wants to fight through IRS red tape, especially when they’re in the right. That’s why it’s important to get all the details on the relationship between your cap table software provider and their 409A valuation partner. Their partnership should be presented simply and transparently. If it doesn’t pass your “smell test” there’s a good chance they’re up to something fishy with your fair market value.
For more information on 409A valuations, safe harbor presumptions, and cap table management in a startup company, check out the Diligent Equity blog. To learn how we’re helping startups and private companies manage their equity, schedule a demo or create your free account today!