“409A” refers to Section 409A of Title 26 of the United States Code (“Income Tax Law”), which deals with deferred compensation. Employee stock options are a form of deferred compensation. For startups issuing stock options, the idea is that employees can purchase stock options at a very low price, during the early days of a company, and then sell their stock later, at a much higher price, after their company has done well and grown much bigger. Typically, the biggest payoff occurs when a company does an initial public offering (“IPO”) of its stock and becomes a publicly traded company. But often, the acquisition of a company by a larger company can also provide a sizeable payoff. In any case, employees typically reap their reward several years after the stock options were initially granted.
Under the Income Tax Law, stock options must be granted with a strike price at or above the “fair market value” of a share of a company’s common stock, in order to avoid a taxable event for the recipients of the stock options. That is, if stock options are granted with a strike price below the fair market value of a share of common stock, the recipients of the stock options will be taxed on the difference between the exercise price and the fair market value. Under the Income Tax Law, that difference is considered taxable income to the recipient. Thus, for startups granting stock options to their employees, determining the value of the company’s common stock is crucially important.
Although neither Section 409A of the Income Tax Law nor the associated regulations put forth by the IRS technically require an independent valuation, the IRS regulations provide a “safe harbor” for privately held companies who obtain an independent appraisal of value from a qualified valuation expert. This regulation effectively forces privately held companies into hiring an external valuation firms to provide a “409A valuations”. This law was enacted in 2007. The background rational for this requirement is that a lot of startups, especially in Silicon Valley, had been abusing the great discretion they had been given in determining the fair market value of their common stock. That is, many companies had been setting the exercise prices of stock options artificially low.
One word of warning – the new IRS regulations that forced companies into getting 409A valuations opened up a brand new boutique industry for CPAs and other valuation experts to provide these valuations to companies. With that, a lot of “used car salesman” entered this market to make what they view as easy money. However, in 2014, the IRS announced that it was commencing audits of compliance with section 409A of the Income Tax Law. Therefore, it is important that you avoid “shade tree mechanics” and make sure you hire a qualified valuation firm who will provide a professional, defensible valuation, in case your 409A valuation becomes the subject of an IRS audit.
At Marpé, we provide 409A valuations quickly and painlessly. We are very diligent and careful in our work, and we will stand behind our valuations in the case of an audit.
Glenn Ballard, CPA is the leader of the 409A valuation practice. Glenn has been practicing corporate finance and accounting since 1995. Glenn has 11 years of experience with “Big 4” accounting firms, including in the merger and acquisitions advisory group of the New York office of Ernst & Young, where he gained extensive experience with business valuations. Glenn was first licensed as a Certified Public Accountant in 1998, and he continues to hold an active CPA license in both California and Georgia. Glenn has been working in Silicon Valley for more than 15 years, and he has worked on many private company valuations during that time.
Glenn holds a Bachelor of Science in Electrical Engineering from the University of Alabama, a Bachelor of Business Administration with a Major in Accounting from Georgia State University, a Master of Taxation from Georgia State University, a Master of Science in Finance from Georgia State University and a Master of Business Administration from the University of California, Berkeley.