Before 2007, it was not considered a taxable event when a company granted stock options. Taxes only came into play when someone sold their stock – but that all changed with the fallout from the Enron scandal.
IRS section 409A was created in response to that scandal to clarify when stock options do and do not count as “tax-deferred compensation.” Essentially, unless a company follows the rules in 409A, options are taxable and subject to stiff penalties if taxes go unpaid.
409A Basics
The most important (but not only) part of 409A compliance is for the strike price of stock options to equal or exceed the fair market value (FMV) of those options. Improperly valuing the company can trigger IRS penalties, which is why most firms rely on outside evaluators to set the valuations and determine the strike price.
Both numbers are important because they determine an employee’s tax liability. When they sell their stock, they pay taxes on the difference between the market price, or current 409A valuation if no market price available, and their strike price of the stock.
3 Types of 409A Valuation Methods
The company’s value – which determines the FMV of the common stock – can be determined several ways:
- Market Approach – By analyzing the value of comparable companies as a basis for valuation.
- Income Approach – By discounting the projected cash flows of the business.
- Asset Approach – By combining the value of all tangible and intangible assets.
Valuation: High or Low?
What are the pros and cons of higher or lower valuations for employees and the company?
A lower valuation is better for employees. The smaller the strike price, the more an employee makes when they sell their stock at a higher price. Since stock options are offered as a reward or incentive to help with recruiting and retention a lower valuation will appear more attractive in the eyes of employees.
That being said, stock sales are a fundraising tool first and foremost, and a higher valuation raises more money for the company when employees exercise their options.
The financial implications of a higher or lower valuations compared to the market price require close consideration.
Final Thoughts on 409A
The value of young companies changes quickly. A 409A valuation stays valid for 12 months or until an event – such as securing qualified financing, gaining or losing a significant customer, or resolving material litigation – affects the value. That means this is an issue that comes up early and often for startups trying to use deferred compensation to attract and reward top talent.
Instead of allowing this to become a liability or limitation, explore how to use 409A compliantly and strategically. Proseer is your advisor through all aspects of startup success – contact us.
