Overview of Internal Revenue Code Section 409A

Section 409A regulates the treatment of nonqualified deferred compensation (NQDC) paid by a “service recipient” to a “service provider” for federal income tax purposes. Sec. 409A has a measurable impact on the way NQDC plans are designed and operated. Failure to adhere to Sec. 409A could result in immediate taxation, a 20% penalty and potential interest payments to the employee. The context in which most commonly encounter Sec. 409A regulations is related to the issuance of employee stock options and other equity instruments.

When issuing stock options, companies must be aware of the following requirements of 409A:

  1. The fair market value must be determined using “reasonable application of a reasonable valuation method;” and
  2. A valuation needs to be performed by someone qualified to perform such a valuation, based on her knowledge, training, experience, etc. (In most cases, companies choose to hire outside appraisal firms to meet this requirement); and
  3. The valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (e.g., new rounds of financing, new product launches, new major customers, etc).

409A Valuation Checklist

In order to comply with 409A, a company may hire a third-party appraiser to perform a valuation. This valuation will ultimately be reviewed by several parties, which could include management,

Internal Revenue Service, the company’s auditors or even the SEC. The following represents a non-exhaustive checklist of items that you, as a reviewer of the appraisal, may want to consider.

  • Is the appraiser qualified?
    • Does the appraiser have previous experience performing 409A valuations? If not, does the appraiser have significant valuation experience that would suggest his/her competency? Has the appraiser’s work been successfully reviewed by auditors?
    • Is the valuation date recent to the grant date?
      • Is the valuation date no more than 12 months prior to the grant date for the options?
      • Have any significant events occurred between the valuation date and the grant date that might affect value?
      • Is the appraiser employing appropriate methodologies to value the common stock? There are generally two steps involved with this type of analysis.
        • The first step involves determining the overall company value.
        • The second step involves allocating the total company value among the various capital owners (e.g., preferred and common shareholders). As outlined in the American Institute of Certified Public Accountants (AICPA) guidelines, the three most commonly used valuation methodologies for the second step are the option-pricing model, probability weighted expected return model and the current value method. Note, the current value method is only appropriate in limited circumstances.
        • Does the appraiser support his/her concluded marketability discount using evidence other than quantitative methods?
          • Many appraisers rely solely on quantitative methods such as put option models to quantify the marketability discount in a 409A analysis; however, IRS will look for evidence beyond quantitative models (e.g., an analysis of restricted stock studies) to support the concluded discount.
          • Did the appraiser consider any recent rounds of financing or recent transactions of the company’s common stock?
            • Has the company had a recent round of financing that it views as arms-length and indicative of fair market value? If so, the appraiser will need to consider the round of financing in the valuation, and may need to rely on the pricing of the round to deduce the common stock value.
            • The secondary transaction market has grown considerably over the last few years, and private company common stock is increasingly being traded over secondary exchanges or otherwise sold to private buyers. The appraiser will need to consider whether this transaction is a relevant indication of value, which can be driven by factors such as the motivations of the buyer and seller, the block size, the level of due diligence performed and other factors.
            • Can the valuation be used for both tax reporting and financial reporting purposes?
              • If you intend to use the appraisal to support your Accounting Standards Codification Topic 718 stock compensation expense (formerly known as SFAS 123R), the appraisal needs to state that it is valid for both tax and financial reporting purposes.

Primary Factors that Influence

Common Stock Value

There are a number of factors that impact a company’s common stock value. While the magnitude and directional impact of these factors can vary depending on a company’s capital structure, stage of development, etc., these factors generally have the following impact on value:

  • Company Value: Any factor that increases the overall company value (e.g., faster growth or greater profitability) will increase the common stock value.
  • Preferred Stock Participation Feature: Most preferred shares contain a conversion option that allows the owner to convert his/her preferred shares into common shares. Some preferred shares, however, have a participation feature allowing them to share in any upside with the common shares without the exercise of the embedded conversion rights (i.e.,“they get to have their cake and eat it too”). The presence of this type of participation feature ultimately increases the value of the preferred shares and reduces the value of the common shares.
  • Preferred Stock Cumulative Dividends: When a company has preferred stock with cumulative dividends, a larger portion of any sale/initial public offering proceeds will be distributed to preferred stock, thereby reducing the remaining value available to the common stock.
  • Sale or Transfer Restrictions: The presence of sale/transfer restrictions associated with the company’s common stock will reduce the stock’s attractiveness and, therefore, reduce its value.
  • Control or Voting Rights: In most cases, a single share of common stock does not have significant control or voting rights. The presence of any material control or voting rights will increase the value of the common stock.

Conclusion

Although IRS has not invested significant resources reviewing 409A appraisals to date, IRS has recently indicated that they now intend to focus on 409A valuations. Obtaining a defensible appraisal is an important step in potentially saving you and your employees from unnecessary IRS challenges and penalties.

Note: You may also be interested in our article, “Why you should care about 409A valuations,” in VentureBeat.

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