Section 409A Valuation

A Section 409A valuation is the determination of the fair market value of a private company's stock, used to set the exercise price of stock options and stock appreciation rights so that those awards fall outside the deferred compensation rules of Internal Revenue Code section 409A. The name comes from the Code section that creates the consequence rather than from anything in the regulation, which does not use the phrase.

What the regulation actually requires is a standard, not a document. Treasury Regulation 1.409A-1(b)(5)(iv)(B)(1) provides that for stock "that is not readily tradable on an established securities market, the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method," and that "the determination whether a valuation method is reasonable, or whether an application of a valuation method is reasonable, is made based on the facts and circumstances as of the valuation date." An independent appraisal is the usual way companies satisfy that standard, because the regulation separately makes an appraisal a safe harbor. It is not the only way, and it is not itself the rule.

What a reasonable valuation method has to take into account. The regulation supplies a factor list rather than a formula. The factors to be considered "include, as applicable, the value of tangible and intangible assets of the corporation, the present value of anticipated future cash-flows of the corporation, the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued," along with "recent arm's length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability."

Two constraints sit alongside the list. A method is not reasonable "if such valuation method does not take into consideration in applying its methodology all available information material to the value of the corporation." And using the same method consistently for other purposes, "including for purposes unrelated to compensation of service providers," is stated as a factor supporting its reasonableness, which is a quiet argument against having one valuation for the option plan and a different one for everything else.

The staleness rule has two triggers and they are disjunctive. This is the answer to "how often do we need a new one," and the part most often stated incompletely. The regulation says the use of a previously calculated value "is not reasonable as of a later date if such calculation fails to reflect information available after the date of the calculation that may materially affect the value of the corporation (for example, the resolution of material litigation or the issuance of a patent) or the value was calculated with respect to a date that is more than 12 months earlier than the date for which the valuation is being used."

So twelve months is a ceiling, not a license. A company that closes a funding round, wins or loses material litigation, is granted a patent, signs or loses a transformative contract, or receives an acquisition offer has new information that may materially affect its value, and a valuation dated before that event is no longer reasonable regardless of how recent it is. A company granting options a week after a priced round on a valuation from the month before the round is relying on a document the regulation has already disqualified.

The presumption, and the standard the government has to meet to beat it. Paragraph (b)(5)(iv)(B)(2) provides that using any of three specified methods "is presumed to result in a reasonable valuation, provided that the Commissioner may rebut such a presumption upon a showing that either the valuation method or the application of such method was grossly unreasonable." That phrase is what a company is buying. Without a safe harbor the question is whether the valuation was reasonable, and the company carries the argument. Inside one, the question is whether it was grossly unreasonable, and the government carries it.

The three safe harbors. They are alternatives, and only one is in everyday use:

• The independent appraisal. A valuation "determined by an independent appraisal that meets the requirements of section 401(a)(28)(C) and the regulations as of a date that is no more than 12 months before the relevant transaction to which the valuation is applied (for example, the date of grant of a stock option)." This is what the market means by a 409A valuation.
• A formula valuation. A value based on a formula that would be treated as fair market value under the non-lapse restriction rules, available only if the same formula is used consistently for every transfer of that class of stock to the issuer or to a more-than-10-percent owner, other than an arm's-length sale of substantially all the company. It is expressly unavailable for stock acquired under a stock right that is transferable other than through a non-lapse restriction. Narrow, and rare outside companies with a genuine standing formula.
• The illiquid start-up safe harbor. Available for stock of a corporation that "has no material trade or business that it or any predecessor to it has conducted for a period of 10 years or more and has no class of equity securities that are traded on an established securities market," where the stock is not subject to a put, call or similar purchase right or obligation, apart from a right of first refusal on a third-party offer and a lapse restriction. It requires a written report taking the (B)(1) factors into account, and it carries the conditions below.

The start-up safe harbor's two windows, and its valuer standard. The safe harbor "does not apply to the valuation of any stock if the service recipient or service provider may reasonably anticipate, as of the time the valuation is applied, that the service recipient will undergo a change in control event ... within the 90 days following the action to which the valuation is applied, or make a public offering of securities within the 180 days following the action." Note that the test is what is reasonably anticipated at the time the valuation is applied, so a company in live acquisition or offering discussions cannot rely on it even if the transaction later falls through.

The regulation also sets a floor on who may perform the valuation, and it is more specific than "a qualified appraiser." A valuation is not treated as made reasonably and in good faith unless it is performed by someone the corporation reasonably determines is qualified based on their knowledge, experience, education or training, and the regulation supplies the benchmark: "significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates."

A valuation cannot be repaired after the fact. Paragraph (b)(5)(iv)(B)(3) allows a different valuation method for each separate action for which a valuation is relevant, "provided that a single valuation method is used for each separate action and, once used, may not retroactively be altered." It gives the example directly: one method may set the exercise price of an option and a different method may value a later repurchase, but "once an exercise price or amount to be paid has been established, the exercise price or amount to be paid may not be changed through the retroactive use of another valuation method." The same paragraph also requires the company to switch to the market-based method under (b)(5)(iv)(A) once the stock becomes readily tradable on an established securities market.

What is at stake if the valuation does not hold. The consequence is in the statute rather than the regulation, and it is worth stating precisely because it is usually paraphrased loosely. Where compensation has to be included in gross income under section 409A(a)(1)(A), section 409A(a)(1)(B)(i) provides that the tax for that year "shall be increased by the sum of, the amount of interest determined under clause (ii), and an amount equal to 20 percent of the compensation which is required to be included in gross income."

Two precision points follow. The 20 percent is charged on the amount included in gross income, not on the discount by which the option was mispriced. And the interest under clause (ii) runs "at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture." The interest is therefore back-dated to the year of first deferral rather than running from the year of the failure, which is what makes the total large on an award that vested over several years.

1. The company decides it needs to grant options and therefore needs a fair market value for its common stock as of the grant date.
2. It engages a valuer it reasonably determines is qualified, with the regulation's benchmark of generally at least five years of relevant experience in valuation, appraisal, financial accounting, investment banking, private equity or secured lending.
3. The valuer applies a reasonable method, weighing the regulation's factors: tangible and intangible assets, the present value of anticipated future cash flows, comparable companies, recent arm's-length transactions in the stock, and adjustments such as control premiums or a discount for lack of marketability.
4. The company checks the safe harbor conditions. For the start-up safe harbor that includes the written report, the 10-year and no-public-market tests, the absence of a put or call, and the 90-day change-of-control and 180-day public-offering windows.
5. Options are granted at or above the resulting value, and the board documents the value it relied on and the report it came from.
6. The clock and the events are monitored. A new valuation is needed at twelve months, or sooner if information arrives that may materially affect value.

A hypothetical shows how the two staleness triggers interact, and why the calendar one is the easier of the two to satisfy.

Thornbury Systems obtains a valuation dated March 15, which supports $2.40 a share.

• Grants on June 1 are fine. The valuation is under twelve months old and nothing material has changed.
• On July 20 the company is granted a patent that its own board minutes describe as central to its product roadmap. The regulation names "the issuance of a patent" as an example of information that may materially affect value, so the March valuation is no longer reasonable, even though it is four months old.
• Grants on August 3 at $2.40 are therefore made on a valuation the regulation has already disqualified. If the shares are in fact worth $4.10 on that date, each option is discounted by $1.70 and falls inside section 409A.
• The consequence on 10,000 options that later vest is not computed on the $17,000 of discount. It is computed on the compensation required to be included in gross income, plus 20 percent of that amount, plus interest at the underpayment rate plus one percentage point, back-dated to the year the compensation was first deferred.
• Had no patent issued, the March valuation would have supported grants through March 15 of the following year and no further. The regulation disqualifies a value calculated "more than 12 months earlier" than the date it is used for, so the anniversary itself is still inside the limb and the day after it is not.

The dollar amounts here are illustrative. The point is the structure: the employee, not the company, bears the tax, the penalty is a percentage of income rather than of the mispricing, and the interest reaches back to the first deferral year.

Pros

• An appraisal moves the question from whether the valuation was reasonable to whether it was grossly unreasonable, and shifts who has to make that case.
• It gives the board a documented, dated basis for the strike price, which is what a later examination, an acquirer's diligence and an auditor all ask for.
• It protects the employees rather than the company. The section 409A tax, the additional 20 percent and the interest fall on the option holder, so getting the valuation right is a duty owed to staff.
• The regulation offers three routes rather than one, so a company with a genuine standing formula or a very early-stage company has alternatives to a full appraisal.

Cons

• It costs money and takes time, on a schedule set by the twelve-month clock rather than by the company's need for it.
• The material-event trigger arrives without warning, so a funding round, a patent or a large contract can invalidate a current report and delay a grant the company has already promised.
• The presumption is rebuttable. An appraisal is protection, not immunity, and a method or application that was grossly unreasonable is not saved by having been written down.
• Judgment inputs, particularly the discount for lack of marketability, move the answer materially, which is why two defensible valuations of the same company can differ.
• Nothing can be repaired retroactively. Once an exercise price has been set it "may not be changed through the retroactive use of another valuation method."
• The start-up safe harbor is unavailable exactly when a company is most active, since a reasonably anticipated change in control within 90 days or offering within 180 days switches it off.