22 Feb Why an Independent 409A Valuation Matters
OptionTrax offers the convenience of 409A valuation subscription services with the security of independent, qualified appraisers.
Whether you’re a private company already issuing stock options or other equity compensation, or just considering issuing this type of incentive, then you’ve likely had (or at least heard of) a 409A Valuation. Whether you’ve had one or not, it’s not too late to learn – simply having a 409A valuation is not good enough! What do I mean by that? A 409A valuation is not simply a “check the box” exercise, a 409a valuation is something that will be reviewed by auditors and may be audited by the IRS. This is why having the right 409A valuation matters!
To understand this, let’s take a step back:
Tell me again why I need a 409A valuation
IRS 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.” Equity awards such as stock options and restricted awards are deferred compensation because they are granted and then have some period of time before they are exercised or released.
The 409A valuation is required by the IRS to determine the “Fair Market Value” of company shares, in the absence of a market (i.e., public stock exchange) to set the price. In order to comply with IRS regulations, the strike price of an option must be set at or above the Fair Market Value at the time of grant. Compliance means avoiding the 20%+ fine to the company and employee, and ensures that your stock options fall under the IRS safe harbor.
What matters in a 409a valuation?
In theory, you can perform your own 409A valuation – however, there is no IRS safe harbor in this case, and the inherent risk far outweighs the cost savings if you are not a valuation expert. Not only are there potential IRS fines on the table, but a bad 409A valuation and the associated issues can put a future possible acquisition at risk.
There are also software providers out there who say they have developed their own software-based 409A valuations. Truth is, these are almost as risky as the DIY method, and only early-stage startups with specific criteria are eligible to do this (e.g., you haven’t raised $500,000, you’re not within 180 days from an IPO or 90 days from being acquired, you have less than $100,000 in assets, etc.). If you’re not in an extremely cookie-cutter stage of development, there just isn’t the sophistication out there at this time to algorithmically develop a 409A valuation that you can feel confident will withstand scrutiny.
Surprisingly, while it seems obvious, this is the aspect of 409A valuations where some of the largest providers are blurring the line today, and their clientsmay not realize that is the case. Independence of the valuation expert make logical sense, it is mandated by the IRS. The guidelines require that “valuators will employ independent and objective judgment in reaching conclusions and will decide all matters on their merits, free from bias, advocacy, and conflicts of interest.” Sounds simple enough, right?
Well, what if the same entity that performs the valuation derives income from selling you the software to issue and manage those valued options? Or even more so, if that same company has an economic interest in making a market for those shares? Doesn’t sound so independent now, does it? Failure to meet the standard of independence can jeopardize your coverage under the IRS safe harbor, not to mention raise flags for potential future investors and acquirers. There is something to convenience, but since the infamous fall of Arthur Anderson, the lesson is clear that cheap convenience can come at the expense of defensible compliance, with disastrous consequences.
So where should you turn for your 409A?
This is why we are so excited to announce OptionTrax 409A valuation services – conveniently bundled with your cap table and equity plan administration software license, but performed and provided by Economics Partners LLC, a leading independent valuation firm that has been providing 409A valuation services for over a decade. That means that unlike some new-to-the-business provider, their methods and results have already been tried and tested. Economics Partners provides the perfect combination of quality and great value – exactly what OptionTrax has been delivering to companies since 1992.
With a simple software interface to upload your valuation input data, in just 7 days you will have a thorough, auditable 409A valuation. We understand that you need to focus your resources on growing your business, and that’s why we are thrilled about this new partnership and the ability to add convenient, affordable, and truly independent and compliant 409A valuations to our portfolio of services.
Elena Thomas, COO