Here is an excellent exposition on 409a stock option considerations when there
are preferred share classes priced more aggressively clouding the issue of Fair
Market valuation. The additional issue comes from tax considerations when the
options are seen as a proxy for insider trading where "tax-deferred
compensation" loopholes are used to drive strike price down and maximise "in the
money" scenarios.
Over here in Malaysia, capital gains tax are only applicable
for property, therefore making it a no-brainer for wealth to be diverted to
public and private asset classes.
https://a16z.com/2020/02/13/16-things-about-the-409a-valuation/
For the purposes
of this article, we assume your company is a U.S.-headquartered Delaware C-corp
granting vanilla call options (simple expiration date and strike price, no
special terms or features) to U.S.-based employees. While this post covers the
most critical points, the American Institute of CPAs (AICPA) publishes the
definitive guide “Valuation of Privately-Held-Company Equity Securities Issued
as Compensation” on all of the generally accepted methodologies and techniques
with easy-to-follow case studies. But first, how did we get here? In the U.S.,
prior to 2007, stock option grants were not considered taxable events. Stock
options (and other forms of tax-deferred compensation) were taxed only when an
employee actually exercised their options to buy the common stock. So what
changed? In a word: Enron. In the U.S., prior to 2007, stock option grants were
not considered taxable events. So what changed? In a word: Enron. Now, for
grants to be tax-free events, companies must comply with Internal Revenue
Section 409A. CLICK TO TWEET In the years leading up to its bankruptcy in 2001,
Enron executives committed a number of misdeeds. Among them, those who were
granted large stock options awards accelerated the vesting of their options and
then exercised and sold stock when the company’s shares were trading at all-time
highs, all the while knowing they were overstating the value of the business to
drive up the company’s valuation. As the fraud came to light, it highlighted
loopholes in non-retirement tax-deferred compensation that until then had
largely been ignored by Congress. The Enron stock option fraud was not covered
by existing insider trading laws, so as a response, Internal Revenue Section
409A was passed as part of the 2004 American Jobs Creation Act. In a nutshell,
Section 409A excludes stock options from the U.S. definition of “tax-deferred
compensation,” unless certain rules are followed. Companies can largely ignore
Section 409A if they give employees stock options that have a strike price (the
price at which the stock can be bought) exactly equal to the fair market value
(FMV) of the common stock at the time of the grant. For publicly-traded
companies, where the fair market value is the current stock price, this is easy.
But it’s not straightforward for privately-held companies, such as startups. As
a concession, provisions were created so that privately-held companies could
determine the FMV of their common shares in a way that would be accepted as
valid by the IRS – what is known as “safe harbor.” However, the new standards of
proof were a radical change from how privately-held companies had previously
determined the FMV of their common stock. Whereas in the past, a company would
decide on its own (with advice from the Board and outside counsel) what they
felt was an appropriate price, they would now have to provide substantial
supporting evidence. Getting Started with 409A #1 Why should I hire a 409A
valuation firm? In order to structure stock option grants as tax-free events to
your employees, you need to prove what you calculated as the fair market value
of your common stock is reasonable, otherwise known as “safe harbor.” The
easiest and most common way to ensure 409A safe harbor is to have a qualified,
independent valuation provider conduct the 409A analysis. A good analogy here is
when your mortgage lender uses an appraiser to figure out how much your house is
worth: They don’t want to know what you think since you’re biased – they want
the value determined by someone who can give them a dispassionate, arm’s-length
assessment. Having said that, hiring an expert doesn’t automatically guarantee
409A safe harbor. As the CEO/founder, you still have a duty to ensure the
valuation work is reasonable and defensible because the IRS (and the SEC, where
applicable) can challenge the analysis, even if it’s performed by an independent
provider. #2 How should I select my 409A valuation firm? You want to select a
provider who has experience valuing companies that look a lot like yours. A
valuation provider should have not only the right credentials and expertise
conducting valuations to ensure 409A safe harbor, but also extensive experience
in your sector, industry, and stage. For instance, don’t engage a valuation
provider whose clients are primarily companies located in the Midwest that are
slow-growing, profitable brick-and-mortar businesses if you’re a high-growth yet
unprofitable enterprise SaaS company headquartered in Silicon Valley (and yes, I
have helped companies where this has happened!). Think of it as analogous to
selecting a tax provider to do your personal income taxes: You would choose a
tax accountant who is not just certified as a CPA, but also has extensive
experience filing taxes for someone just like you, so you can leverage their
experience across those similar clients to optimize your tax return without
triggering audit flags. You also want to select a valuation provider who has
strong relationships at major audit firms – the Big-4 accounting firms
(Deloitte, PWC, KPMG, and E&Y) and/or large regional firms in your area – with
the relevant sector heads/partners at that firm’s venture practice. This is a
good indicator the valuation firm has proven their work is defensible and
respected by experts in the audit community. Daniel Knappenberger, Silicon
Valley Market Leader at Deloitte Advisory notes that “for private companies, a
409A analysis is very important and it is critical to have the right level of
support for any conclusion of value. Working with a valuation advisor who has
the relevant experience can help companies shape their point of view and save
them a lot of potential pain down the road.” #3 How often should I do a 409A
valuation? Companies are expected to conduct 409A valuations at least once every
12 months, or when a material event has occurred that would affect the value of
the company – whichever occurs sooner. “Material events” can include new equity
financings; an acquisition offer by another company; certain instances of
secondary sales of common stock; and significant changes (good or bad) to a
company’s financial outlook. A company credibly approaching IPO will also
conduct 409A valuations more frequently (e.g. quarterly or even monthly). #4
What do I need to do a 409A valuation? The data you need to provide to your 409A
provider is relatively straightforward, and your 409A provider will spend time
with you to get additional context on your company and any unique circumstances
you may have. Your sector / industry Most recently amended articles of
incorporation: Also known as the corporate charter, or certificate of
incorporation; your outside counsel will have this if you don’t. Most recent cap
table: Again, your outside counsel will have this if you don’t. Board
presentation and recent pitch deck (if you just completed a fundraise) Company
historicals and 3-year profit and loss (P&L), cash balance, and debt
projections: If you’re an early stage company, this is a best effort, as it’s
hard to predict where a company will be in 12 months, much less three years.
Estimate on how many options you expect to issue over the next 12 months: A good
back-of-the-envelope estimate is take your hiring plan and multiply this by the
median number of options per employee, adjusting for any “option expensive”
hires (e.g. VP and C-level executives, Director of Engineering). A list of 5+
publicly-traded companies most comparable (“trading comps”) to yours: If your
company doesn’t fit into an exact category, that’s okay – most founders start
disruptive companies, so it’s not uncommon to not fit perfectly into an existing
industry. However, make sure the comps make sense to you because they will be
part of your subsequent 409As. Your comps should only change if someone is
acquired or new companies go public that make sense to include. Timing
expectations around potential liquidity events (e.g. IPO, M&A) Significant
events that have happened since your last 409A #5 How long does a 409A valuation
take? Generally, if you have all the items in the above checklist, it takes
about two weeks to get to a final draft of your 409A valuation for your Board to
approve. For later-stage companies who have engaged an auditor (more on that in
#6), the timeline may be a little longer. A typical timeline involves data
collection and kick-off calls, valuation modeling, preparation of draft
schedules, and management review in the first two weeks; and then obtaining
Board approval and granting options the third week. #6 How involved should my
auditor be? For most startups, once you reach around $10M of annual revenue,
investors will expect you to start presenting audited financials. The 409A
valuation is a key driver in calculating stock compensation expense, so your
auditor will most certainly review it. Involving them early in the 409A
valuation helps to ensure a smooth audit process. As a best practice, include
the audit team in the kick-off call with you and your 409A provider prior to
conducting a new 409A valuation. In this call, it’s important that everyone
agrees on the approach and valuation methodology (which we’ll cover in “The
Calculations” section below). If the valuation is complex enough, or you’re
anticipating an IPO within the next two years, then the auditor may request that
their valuation specialist review a draft of the 409A valuation before you
finalize it for Board approval. This sign-off step will add a minimum of one
week to the timeline. It’s critical to get everyone on the same page. In the
event your auditor identifies a flaw in a 409A that you’ve used to grant
options, they will require you to revisit (and potentially revise) not just that
409A valuation, but also prior 409A valuations. This can be a lengthy and
painful process, and any option grants that are outstanding will be put on hold
until the 409A valuations are sorted out. 409A Valuation Calculations In this
section, we break down the three steps that are involved in the 409A valuation
itself. Calculate enterprise value. The first and arguably most important step
is estimating the company’s valuation (“enterprise value”). This is very
straightforward if you’re doing your 409A valuation immediately after a
fundraise, but becomes fuzzier a year (or more) after the fact. Determine the
value of the common stock. The second step is to take that enterprise value and
divvy it up among all the different share classes (e.g. preferreds, warrant
holders, common) to determine the current value of the common shares – what is
also known as the “fair market value” (FMV). This step takes into account all of
the economic rights of each share class, otherwise known as liquidation
preference (i.e. the order in which stockholders are returned their investment
in a liquidity event) and rights related to conversion, dividends, and
participation. Apply a discount for lack of marketability (DLOM). The third and
final step is to take the calculated FMV for the common shares and apply a
discount to adjust for the fact that the company is not publicly traded – in
other words, none of your employees could actually go and sell their shares at
that price because there is no liquid market for them. The 3 steps to 409A
Valuations: 1) Calculate enterprise value. 2) Determine the value of common
stock. 3) Apply a discount for lack of marketability. CLICK TO TWEET #7
Calculate enterprise value While there are many ways financial experts (e.g. M&A
experts, equity research analysts, VC firms) can determine enterprise value, in
409A valuation work, there are three main methodologies: market, income, and
asset-based. These can be used in combination with each other and the method(s)
may change as a company matures. For instance, it’s common for early stage
companies to rely heavily on a market approach, while more mature, growth-stage
companies are more likely to use an income approach. MARKET APPROACH When it’s
used: For unprofitable, early stage companies where it’s difficult to predict
long-range financial performance. How it works: The market approach is a
relative valuation method, which means the company is compared to a set of
publicly-traded companies (“trading comps”) that are similar to it, usually by
industry. This comp set is then used to determine the appropriate valuation
multiple to apply to the company’s own set of metrics to arrive at an enterprise
value. For profitable companies, this is typically an EBITDA multiple, but in
the case of early stage companies where EBITDA is often negative, revenue
multiples are used. This is called the Guideline Public Company method. Pros &
Cons: The benefit of this methodology is it’s very easy to calculate
publicly-traded company multiples. The limitation is oftentimes the comp set may
not be a great representative peer group because the company doesn’t fit
perfectly into a particular category. Many startups are trying to create new
industries/markets, and so in these cases, by definition their comps will be
imperfect since nobody else is doing what they do. More often than not, the
company is also growing at a very different rate compared to its publicly-traded
comps (hopefully much, much faster), but also at a very different scale
(startup: small vs. public companies: very large), so adjustments are made to
try to take into account that the comparison is not perfect. If you’ve just
completed a fundraise, determining enterprise value is actually very
straightforward: the valuation of that round is used. This is called a backsolve
and will almost always be the way a founder will first encounter a 409A
valuation, since they’ve now received funding and can hire their first
employees. A backsolve is considered a “market approach” for calculating the
enterprise value of a company, but instead of building public comps and applying
multiples to metrics (as with the Guideline Public Company method outlined
above), that round’s valuation is used as the anchor to back into (backsolve)
the implied total equity value of the business based on the given mix of share
classes and their rights and preferences. The 409A provider is able to use the
valuation from that fundraise because the new preferred investors (e.g. VC
firms) are assumed to be sophisticated, with the transaction done at arm’s
length, with both buyer and seller acting independently from each other and in
their own self interest. INCOME APPROACH When it’s used: The income approach is
used primarily by companies who have achieved scale, a high degree of visibility
and predictability in their financial performance, and line of sight to when
they expect to become profitable. How it works: This methodology assumes that a
company’s value is determined by the receipt of future profit streams. The
company’s long-range financial projections are used to determine what these
income levels are, which are then discounted back to what they would be worth in
today’s dollars (“present value”). The income approach is also called the
discounted cash flow (“DCF”) method. Pros & Cons: The benefit of this
methodology is it’s directly influenced by the future expected profit from the
company. The downside is it requires reliable long-range forecasts that must be
substantiated. Danny Wallace, Co-Leader of the Emerging Companies Services Group
at PwC notes “the income approach requires the most audit effort. The reason is
it involves assumptions that are inherently subjective, such as revenue growth,
customer attrition, gross margins, and operating expenses, which become
progressively more difficult to forecast the further out you go in the 10 years
of the cash flow period. Without a relatively sophisticated FP&A [financial
planning & analysis] function in place, companies may struggle to provide
sufficient support to satisfy their auditors.” ASSET APPROACH When it’s used:
For venture-backed companies, the asset approach is rarely used; when it is, it
is typically in the very early stage before any formal (i.e. pre-angel)
financing occurs. For instance, a very nascent life-sciences company funded only
through academic grants would be a candidate for the asset approach. How it
works: This approach uses replacement cost to determine a company’s enterprise
value. For this method, the appraised value of all the assets and liabilities of
the company determine its enterprise value. Pros & Cons: The benefit to the
asset approach is it doesn’t require any kind of forecasting because the
potential growth of the company is completely ignored. This is also the downside
to the asset approach. Additionally, it can be prohibitively expensive to
appraise certain assets and liabilities – especially intangible assets such as
IP – making this an impractical method for early stage companies. Once a
company’s enterprise value is determined, the next step in a 409A valuation is
to assign the various equity classes their fair share of the company, taking
into account economic rights such as liquidation preferences, participation
rights, and conversion ratios. #8 Determine the fair market value (FMV) of the
common stock In the case of a company with only common shares (extremely rare
for a privately-held, venture-backed company), the FMV would just be the
enterprise value divided by the fully diluted shares outstanding. However, most
privately-held venture-backed companies have at least two, if not more, classes
of equity (e.g. Series A/B/C/D/etc. preferred shares along with common shares).
In these cases, calculating the FMV of the common shares requires further
analysis. There are three ways to allocate the enterprise value across multiple
share classes. We’ll go from most often used for VC-backed companies, to least.
OPTION-PRICING METHOD (OPM) How it works: All of the company’s various classes
of stock are treated as if they are call options and assigned exercise prices
(the price at which the option holder can buy the stock). In the case of
preferred stock, the exercise price is determined by the liquidation preference.
In the case of common stock, the money left over after all of the liquidation
preferences have been satisfied is used to determine its exercise price. In the
unfortunate situation where a company is acquired for less than or equal to the
liquidation preferences, the shareholders of common stock receive $0 (assuming
no management carve outs). When it’s used: OPM is most frequently used for
companies that are still too early in their development to identify specific
exit scenarios and their timing. Black-Scholes: Black-Scholes is the most
commonly-used option-pricing model in a 409A valuation. We won’t go into a
lengthy technical explanation of how it works, but at a high level, the
Black-Scholes model calculates the value of an option by averaging all the
possible future “profit” on that call option’s strike price (i.e. future stock
price >= current option strike price, otherwise known as when an option would be
“at or in the money”). For a 409A valuation, a handful of key assumptions drive
the output of the Black-Scholes model: the enterprise value of the company
(explained above), volatility, and the expected time to exit (TTE). Your
company’s volatility is determined using the set of publicly-traded companies
that were identified as your “trading comps” from step 1. The more volatile a
stock, the higher the chances the option will expire in the money, which
increases its value. As with the case of determining the appropriate multiple to
use, adjustments are made to take into account the imperfect nature of the
trading comp set. The expected time to exit is simply the amount of time until a
liquidity event (e.g. IPO or M&A). The longer the time to exit, the more
valuable the option, since more time gives the option an increased chance to
expire in the money. PROBABILITY-WEIGHTED EXPECTED RETURN METHOD (PWERM) How it
works: In this method, various outcomes – specifically IPO, M&A, dissolution, or
continued operations – are modeled at their projected values and then each is
assigned a level of probability of occuring, with how each share class
participates in those outcomes dictated by their respective rights. Common stock
values tend to be higher in PWERMs than in OPMs because in the IPO scenario all
of the preferred stock converts to common, which eliminates the liquidation
preferences. When it’s used: This method is most frequently used for companies
that have matured to the point where they can estimate with reasonably strong
confidence potential exit scenarios along with their timing (e.g. IPO in 18
months). HYBRID METHOD How it works: The Hybrid Method is a combination of using
both OPM and PWERM, estimating the probability-weighted value across multiple
scenarios, but using OPM to estimate the allocation of value within one or more
of those scenarios. When it’s used: The Hybrid Method can be a useful
alternative to explicitly modeling all PWERM scenarios in situations where the
company has insight into one or more near-term exits (e.g. M&A in 6 months), but
is unsure about what would occur if those specific plans fell through. CURRENT
VALUE METHOD (CVM) How it works: This method estimates the company’s present-day
equity value (in other words no assumption of future progress) and assumes there
is an immediate sale or dissolution of the company. Value is then allocated
across the share classes based on liquidation preferences, conversion ratios,
and participation rights. When it’s used: For a venture-backed company, it’s
very rarely used. The only time the CVM makes sense is when the company is at
such an early stage that either no material progress has been made vs. the
company’s expectations (and thus no value above the liquidation preference has
been created) or there is no way to reasonably estimate a time when the company
could create value above its liquidation preference. #9 Apply a Discount for
Lack of Marketability (DLOM) The last step in a 409A valuation is to apply a
discount for lack of marketability (DLOM) to the common stock value calculated
in step 2. The equity allocation models used in step 2 assume there is an active
market to immediately buy and sell the common stock – in other words, fully
marketable (publicly-traded) stock. This isn’t the case for the majority of
privately-held companies and so their common stock is less valuable because of a
“lack of marketability.” To adjust for this, a DLOM is applied to the calculated
fair market value. This lack of marketability decreases as the company scales
and becomes more and more likely to be successful. A company who has just raised
a Series A may have no interested buyers in its common stock and therefore has a
very large DLOM, whereas a company who has reached scale and is a credible
candidate to be a publicly-traded company has a very small discount. The primary
variable that affects the size of the DLOM is the time to a liquidity event. In
other words, how long will the owner of the shares have to hold onto them before
they can be openly exchanged and sold? Most DLOM studies conclude a discount in
the 25%-35% range for a two-year holding period. Discounts greater than this are
reasonable if the time to a liquidity event is many years in the future. In the
case of a backsolve (see #7), your DLOM will actually likely be lower than these
ranges because the 409A valuation is benchmarking to a preferred instrument,
which implicitly incorporates a certain lack of marketability into the pricing
from the VC investor. 409A Valuation Myths Companies want to keep the common FMV
low since it makes stock options seem more lucrative to employees and recruits.
However, pursuing the lowest possible value at all costs can create serious
consequences for your company and your employees. While the 409A valuation
framework has become well established, some myths from the early days have
persisted. In this section, we bust the four most common. #10 MYTH: Your common
stock is worth 20% of the last round’s price Gone are the days where a private
company, working with its Board and outside counsel, could just use a rule of
thumb to set common stock FMV at 10-20% of the most recent preferred round (yes,
this really was how option strike prices used to be set at private companies!).
Only in rare instances is a privately-held company’s common stock FMV
legitimately 10-20% of the value of its preferred stock – even with early,
seed-stage companies. So, if anybody tells you your 409A is too high and should
be “X% of the preferred,” they’re giving outdated advice. “Percent of preferred
is one of the most misunderstood – and anachronistic – metrics in the venture
world,” notes Bob Chung, Director of Valuations at Carta. “The ratio is highly
dependent on a given company’s ability to negotiate favorable financing terms at
a specific point in time. It can’t be applied as a benchmark across a range of
disparate companies.” The truth is without running through an actual 409A
valuation analysis, no one can know what the FMV of your common stock should be
off the top of their head. There is no “rule of thumb,” and every company is
unique. I’ve seen valuations come back that sounded way too low, but it turned
out they were reasonable because of the economic rights of the preference stack;
I’ve also seen FMVs that seemed way too high but were in actuality reasonable
because of the significant progress the companies had made since their last
409As or because the methodology justifiably changed. Without running through an
actual 409A valuation analysis, no one can know what the FMV of your common
stock should be off the top of their head. There is no “rule of thumb,” and
every company is unique. CLICK TO TWEET #11 MYTH: You can use a different
forecast for your 409A valuation than your Board forecast In the early days of
409A, this was a commonly-used tactic, but companies can no longer get away with
it. While it may be tempting not to give your 409A valuation provider the true
company forecast – the one that you’re reporting to your Board – and instead
provide an artificially low set of projections to try to keep the value of your
common stock low, the company’s forecast is one of the very first places someone
will look to make sure the assumptions used in the analysis were reasonable.
They will verify this was the version you were using to run the business; if it
isn’t, it will cause issues with your auditors (where applicable), and
invalidate the 409A safe harbor, opening up huge risk to your employees. #12
MYTH: Do whatever it takes to get the lowest strike price When it comes to
strike price, small changes you manage to squeeze out of your 409A aren’t going
to make much of a difference to your employees’ take-home when there is a
meaningful liquidity event. Let’s walk through the math on how the economic
difference of pennies, dimes, or even dollars in strike prices won’t have a
significant material impact in the big picture of a liquidity event: As an
example, let’s say an employee is given an initial grant of 100,000 options with
a strike price of $0.35. Six years later, the company has an exit where the
common shares are worth $50. Here’s this employee’s take home before taxes on
that grant: ($50 – $0.35) x 100,000 shares = $4,965,000 Now let’s say instead of
$0.35, the strike price at the time of that employee’s grant had been $2.00.
Then the take home before taxes would have been: ($50 – $2.00) x 100,000 shares
= $4,800,000 While the difference between the two strike prices of $0.35 and
$2.00 looks significant (471%!), the actual financial outcome had a 3%
difference. The key takeaway here is it’s important to keep things in
perspective. Your common stock is going to appreciate in a way that’s reflective
of the progress you’re making in building your company. Keep in mind: doing
things that could invalidate your 409A safe harbor will open up your employees
to significant taxes and penalties (see #15), dramatically reducing what they
net from their options. If you feel the FMV is starting to “sound expensive”
from an ability-to-recruit-new-hires perspective, you can consider doing a stock
split to get the strike price back down to a level you feel makes you sound more
competitive. #13 MYTH: The strike price must be exactly the same as the 409A FMV
While you can’t choose an option strike price that is lower than the 409A
valuation’s calculated FMV, you can set a strike price that is higher. The
relevant regulatory and tax authorities are generally only concerned when the
strike price was set at a level that was lower than the 409A valuation
supported: For the IRS, it would mean employees had actually received discounted
(“in the money”) stock options that then would have been taxable at the time of
grant; and for the SEC, it would indicate that the company was understating its
stock compensation expense to artificially improve its profitability. Setting
the strike price higher than the 409A FMV can be useful in situations where the
company’s enterprise value (see #7) has declined since the last 409A valuation.
Such cases include when the prior 409A valuation is now significantly ahead of
the company’s current traction (and the new 409A is therefore lower), or in a
down-round situation. In these instances, the company can opt to keep the strike
price “flat” – the same value as the prior 409A valuation – to preserve employee
morale. However, be realistic when making this kind of decision: what will
likely happen between now and the next 409A; are you confident this is just a
one-time blip in the company’s progress? Good intentions, unintended
consequences In this section, we cover a few of the consequences of having an
overly-aggressive 409A valuation. “Your 409A follows you around, and shows up in
secondary transactions, tax issues, audit review, and of course, in the pre-IPO
phase” notes Steve Liu, Head of Shareworks Valuation Services, “It’s got to be
right.” #14 Hurts employee morale For early stage companies where an audit is
more than two years away, the reality is there is less risk having an aggressive
409A valuation compared to larger, more established companies. Having said that,
there will come a time when that window closes, as it inevitably does when you
build a successful company. When it happens, you will face a significant step-up
to your FMV as you come off a too-aggressive 409A and are effectively forced
into a clean valuation. Now you’ve inadvertently created a situation where one
group of employees has very low-priced options and another group – some who will
have started only days or weeks after the early group – with significantly
higher priced ones, even though the business hasn’t changed that materially. Now
you have a world of “haves” and “have-nots,” because inevitably, employees will
talk to each other and resentment can then build up. This issue will stay with
you, coming up every time you have compensation discussions involving those
employees. #15 Creates significant tax burdens for your employees The financial
consequences for 409A non-compliance can be severe to your employees. If the IRS
were to get involved and determined your 409A valuation didn’t fall under safe
harbor, all of the stock you granted to your employees under that FMV – not just
the current taxable year, but any prior year – become included as part of their
gross income (including interest owed) all at once in that year. The IRS can
also levy up to a 20% penalty on stock options that vested prior to that tax
year. As an example, let’s say you granted an employee 100,000 options that vest
over four years at a strike price of $0.25. Two years after you granted these
options, the IRS reviews your 409A valuation from that grant and determines the
$0.25 FMV didn’t fall under safe harbor because of flawed methodologies, and the
common stock actually had been worth $1.00. Here is the math on what your
employee would owe in that tax year at the federal level (we won’t walk through
federal interest owed or what would be owed at the state level): Federal income
tax rate = 37% (assume highest bracket for a single filer in 2020) Federal 409A
penalty = 20% Option grant strike price = $0.25 Current FMV in year 2 = $5.00 #
of common shares vested at 2 years = 50,000 Taxable income = $232,500 (50,000
shares x [$5-$0.25]) Federal income tax = $86,025 (37% x $232,500) Federal 409A
penalty = $23,750 (20% x 25,000* shares x [$5 – $0.25]) Total federal taxes &
penalties* = $109,775 *PENALTY ONLY OWED ON PRIOR YEAR’S VESTED OPTIONS, NOT
CURRENT TAX YEAR This $109,775 is actual cash the employee will have to pay to
the IRS, and it doesn’t matter that the employee didn’t exercise their options
to sell a single share, or that there was nobody to whom they could sell those
shares even if they did exercise. Because the stock options were not granted at
FMV in the eyes of the IRS, but rather 75% below FMV (at the $0.25 strike
price), the option grants do not fall under safe harbor. As the options vests,
this is considered taxable income – with a penalty tacked on for the taxes that
weren’t paid on the prior year’s vested options. All over $0.75! On top of this,
there will be taxes owed in any future year where that option grant continues to
vest. If FMV continues to increase, then the tax liability also increases:
Option grant strike price = $0.25 Current FMV in Year 3 = $6.50 # of common
shares vested at Year 3 = 25,000 Taxable income = $156,250 (25,000 shares x
[$6.50-$0.25]) Federal income tax in year 3 = $57,813 (37% x $156,250) Again, it
doesn’t matter whether this employee actually sold a single share or not! The
IRS will expect them to pay $58K in income tax on that year’s vested options.
(And this will happen for one more year since the options vest over 4 years.)
Worse, the tax issues won’t end with the federal government. State and local
income taxes will also come into play. “The states have focused on equity
compensation in recent years. California, in particular, reviews equity
compensation arrangements to determine whether an employer and employee have
reported correctly and routinely imposes penalties on top of a tax rate that can
climb as high as 13.3%,” notes Eric Anderson, Managing Director of the SF Bay
Area State and Local Tax practice at Andersen Tax. Moral of the story: Always
retain a qualified and independent 409A valuation firm, and make sure the
valuation work is defensible so that safe harbor applies and option grants
remain tax-free events for your employees. #16 Negatively affects an acquisition
or IPO During M&A due diligence, the acquirer will review your 409A valuations.
Generally speaking, bad 409A practices tend to look sloppy and won’t do you any
favors to setting the tone for negotiations. If the buyer determines they aren’t
comfortable with the 409A valuation(s), they can alter the terms of the
transaction so that any financial burden associated with the mispriced options
are not their responsibility, they can require that you indemnify them for the
risk, or they can require that you pay (or force your employees to pay) any
associated penalties and taxes related to the affected option grants. From an
IPO standpoint, the SEC will review option issuances for the 12-18 month period
preceding an IPO. If there is a significant difference in the option strike
price and the proposed IPO price, the SEC could determine the options were
granted below their actual fair market value (and thus, “in the money”). This
will generally require the company to take an accounting change related to cheap
stock, which is not great to have to disclose to potential investors as it can
be construed as a reflection of the quality of management. Andy Barton, Partner
at Goodwin & Procter LLP points out, “409A valuations are open to challenge by a
variety of actors, including not only the IRS, but also potential buyers in a
transaction, or the SEC in an IPO. It is imperative to get it right.” The Bottom
Line A better approach to your 409A valuation: view them as part of the
narrative of your company’s progress. Done well, you can tell a story that
informs and inspires employees and candidates. CLICK TO TWEET Your 409A
valuation is a direct reflection of the company building and shareholder wealth
you’re creating. While you should absolutely work with your 409A provider to
optimize the valuation, don’t resort to using questionable valuation methods
and/or assumptions – doing this can have serious, unintended consequences, as
we’ve outlined above. A 409A valuation isn’t an exercise in “maximizing the
minimum,” where the goal is to have the common stock appreciate as little as
possible from the prior FMV. If that were the case, you’re making the claim that
between your last 409A valuation and now, the company made almost no progress at
all – meaning you created very little value. A look at your company’s KPIs and
financial performance would provide anyone a quick assessment of whether this is
actually true. Don’t look at the current valuation in a vacuum – all your 409As
are connected to each other. If your company is growing revenue quickly, but
your 409A value isn’t to some degree keeping up, something is clearly fishy
(unless you have a lot of structure to your preferred equity, such as
participation rights). A better approach to your 409A valuations is to view them
as part of the narrative of your company’s progress. Ideally, the FMV of the
common stock will have a nice smooth, upward progression that mirrors the
growing success of your company. The appreciation in your common stock’s value
is an opportunity to message the value proposition of your company. Done well,
you can tell a valuation/wealth creation story that informs and inspires
employees as well as new-hire candidates. Many thanks to these other experts
contributing their thoughts: Eric Anderson, Managing Director, SF Bay Area Sales
and Local Tax practice, Andersen Tax; Andy Barton, Partner, Goodwin LLP; Bob
Chung, Director of Valuations, Carta; Daniel Knappenberger, Silicon Valley
Market Leader, Deloitte Advisory; Steve Liu, Head of Shareworks Valuation
Services; Danny Wallace, Co-Leader of the Emerging Company Services Group, PWC.
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