Section 409a Impacts the Valuation of Stock Options

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Before going into the various aspects of Section 409a, it will be relevant to understand what it is all about. Code 409a places certain restrictions on compensation that is earned in one year but is payable or paid in a future year. This is known as “non qualified deferred compensation”. Hence stock options that have an exercise price that is less than the fair market value of the stock on the grant date are considered to be deferred payment under 409a.

Valuation of Stock Options

In a nutshell, the 409A name comes from IRS Section 409A. Added as part of the American Jobs Creation Act of 2004, it states: “Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.”

If 409a is applicable, stock options may be exercised only upon certain events. These are separation from service, death or disability, change in control event, a specified fixed schedule or time and an unforeseeable emergency. Therefore, 409a would be violated if the stock option is exercised any time within the option term which extends over a number of years.

The next point is – as a business owner why would you need to engage professional and expert 409a valuation services to stay outside the ambit of the IRS 409a audit. While you would be having a fair idea of the value of your business, you need to be precise and specific in this regard so that you can satisfy all provisions of the valuation.

This valuation is applicable for all companies that issue employees with deferred compensation options.  The options offered can be traditional or non-traditional forms of compensation and covers a wide range of alternatives. These include salary deferral agreements, restricted stock units, severance agreements, bonus plans, stock options and employment agreement and offer letters amongst others. Given its complexity, it is therefore recommended that you hire the services of a 409a valuation expert for arriving at the fair market value of your business.

The Section 409a valuation specialist that you hire will deploy a variety of methods to arrive at the enterprise value. Some of the common ones are the current value method, probability weighted return method, option pricing method. This will be done to assign an enterprise value to the equity of the company to one common share.

409a valuation calculator will take into account various aspects as laid down in the section. For one, if you plan to offer common stock options you must get the valuation done twice – one every 12 months and whenever your company closes a common funding round.

Not pricing your stock options can have a damaging effect on your business as the IRS considers it to be giving away something that is valuable and hence can lead to major tax complications. 409a valuation start-up is generally not done as start-ups usually do not face a 409a audit from the IRS. However, you are likely to come under the 409a audit net if your start-up is a highly successful venture and is making money. Additionally, you might have to face serious questions from the Securities and Exchange Commission that scrutinises pre-IPO stock awards.

Taking all these factors into account opt for a 409a valuation to protect your company and employees.