To give shares or options to your US taxpaying employees, you need to first establish the fair market value (FMV) of the shares. To do this and comply with IRS rules (the US equivalent of HMRC), you’ll need to engage an independent specialist to compile a 409A valuation report. In this post, we explain what it is and how it works.
- Why do you need a 409A valuation?
- What is the 409A valuation?
- How often do you need a 409A valuation?
- How to complete a 409A valuation
- Key components of the 409A valuation report
- How to choose the right 409A valuation provider
- The importance of 409A valuations: final thoughts
Shares or stocks?
In the UK, company equity is referred to as shares. In the US, stock is the more common term.
Because the 409A is only necessary when working with US employees, we use the term stock in this article when discussing IRS rules and regulations.
Why do you need a 409A valuation?
As a business, you want to offer a compelling reward package to help attract and retain the best team members.
That’s why employee share and share option plans are such a common feature of compensation packages in the UK. As well as supporting recruitment, the opportunity to earn company equity helps to motivate the team and to keep everyone focused on achieving long-term goals.
For UK listed companies, it’s simple to understand how much the shares are worth to an employee, because the value of each share is publicly available on the stock exchange. However, for private companies it’s not so transparent.
When your private company wants to issue shares to your employees, you need to first determine an appropriate value for these shares. The valuation is important because it helps make sure that the share options are granted at a fair price, avoiding potential tax issues for the employee who receives them.
As the world shrinks, work is more flexible and there are more workers available so your UK company might find itself employing staff in different tax jurisdictions. This means that your employee reward packages will be subjected to different tax treatment depending on the employee’s tax jurisdiction. Not only that, but the process of assessing the market value of your shares can differ between countries.
Regardless of where your business is located, if you employ US taxpaying citizens and offer them shares or share options, you’ll need to get a 409A valuation completed.
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What is the 409A valuation?
A 409A valuation is a process that defines the value of a private company's stock and establishes the fair market value (FMV) of the company for the purpose of issuing stock options or other forms of equity compensation to employees. Why 409A? It’s named after Section 409A of the US Internal Revenue Code.
For UK employees, companies can choose to issue shares through one of the UK government’s tax-advantaged employee share schemes (for example, the popular EMI share option scheme). This involves agreeing a market value for the shares with HMRC, to which the company can apply a discount to make the share options an attractive incentive to the employee.
The 409A valuation works differently. It defines ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’ (ASCT 820).
In plain English, this means that no special treatment or discount can be applied to the employee’s share options. This is the key difference between the UK and US when it comes to employee share valuations.
What’s the risk of offering share options to US employees without the 409A?
If your US employee receives stock options without a 409A valuation or at a valuation that is later deemed to be inaccurate, they could face heavy penalties. As well as being immediately taxed on the difference between the fair market value of the stock and the exercise price of the options, the employee might also be required to pay a 20% penalty tax.
How often do you need a new 409A valuation?
You must complete a 409A valuation each time you issue stocks or stock options to your employees .
Under US tax law, companies are required to do a 409A valuation at least once every 12 months, or whenever a ‘material event’ takes place that could affect the company's value, whichever comes first.
Some examples of material events include:
- new financing and the issuance of new equity - for example in a funding round
- significant positive or negative changes to the company's financial outlook
Additionally, companies that are actively progressing towards an IPO will typically carry out 409A valuations more frequently, potentially quarterly or even monthly.
How to complete a 409A valuation
The 409A valuation must be carried out by an independent specialist.
Key components of the 409A valuation report
There’s no definitive template used to create a 409A valuation report. However, there are three key points that should be included in the report:
- the valuation itself
- the methods that were used to come to that valuation
- information about the specialist who created the valuation for your company
The contents of the report will vary depending on the unique circumstances of your company and the procedures of the specialist you use to compile the report.
Here’s a brief list of the types of information you can expect to see in a 409A valuation report:
- Company overview: A description of your company, including its business model, industry, and relevant market conditions.
- Financial analysis: An examination of your company's financial statements, including historical financial performance, projected financials, and any relevant financial ratios or metrics.
- Valuation methodology: A detailed explanation of the methods and approaches used to determine the fair market value (FMV) of your company's stock. This may include the income approach, market approach, and asset-based approach:
- Market approach: This includes a valuation analysis based on the prices at which comparable companies have been bought or sold.
- Income approach: A valuation analysis based on the present value of projected future cash flows or earnings of the company.
- Asset-based approach: Based on the balance sheet and in particular the net asset figure, additionally taking into account the liquidity of each asset.
- Comparable company analysis: A comparison of your company's financial and operational metrics to those of similar publicly traded or recently sold companies in the same industry or market.
- Discounted Cash Flow (DCF) analysis: A valuation technique that estimates the present value of the company based on its projected future cash flows, considering factors such as growth rates, discount rates, and terminal value.
- Capitalisation Table (Cap Table): A summary of your company's equity ownership structure, including the number and types of shares, ownership percentages, and any outstanding options, warrants, or convertible securities.
- Risk factors: Identification and assessment of the key risks and uncertainties that could affect your company's valuation, such as market volatility, competition, regulatory changes, or reliance on key customers or suppliers.
- Management and governance: An evaluation of your company's management team, including their qualifications and experience, as well as an assessment of your corporate governance practices.
- Reporting and compliance: Proof that your company complies with the specific requirements of Section 409A of the Internal Revenue Code, including documenting the process, assumptions, and procedures used in the valuation, as well as confirmation that your company adheres to any applicable reporting and disclosure requirements.
- Conclusion and opinion: A summary of the valuation results and a statement of the specialist's professional opinion on the fair market value of the company's stock.
How to choose the right 409A valuation specialist
To make sure you get a reliable and accurate valuation, you need to choose the right 409A valuation provider. Here’s what to consider when selecting a specialist:
- Experience and expertise: Look for a valuation provider with extensive experience in 409A valuations. Consider their track record, the number of valuations they have carried out, and their expertise in valuing companies in your specific industry or sector.
- Qualifications and credentials: Evaluate the qualifications and credentials of the specialists who will be involved in the process. Check they have relevant certifications, such as Certified Valuation Analyst (CVA) or Accredited Senior Appraiser (ASA), and a strong understanding of the valuation principles and methodologies.
- Reputation and references: Research the reputation of the valuation provider by checking client reviews, testimonials, and references. Get in touch with companies that have previously worked with the provider to ask about their experience, the quality of the valuation report, and the specialist’s responsiveness and professionalism.
- Compliance and reporting: Check that the valuation specialist has a comprehensive understanding of the regulatory requirements and compliance standards related to 409A valuations. Are they familiar with IRS guidelines? Do they maintain strict adherence to valuation reporting standards?
- Customisation and flexibility: Assess the specialist’s ability to tailor the valuation to exactly what you need. They must be willing to understand your business and consider unique factors that could affect the valuation, such as recent funding rounds, market conditions, or industry-specific factors.
- Timeliness and efficiency: Consider the specialist’s ability to deliver valuations within the required timeframe. A reliable provider will have efficient processes in place to gather necessary data, perform analysis, and deliver the final valuation report on time.
- Cost and value: Compare the cost of the services offered by different valuation specialists. While price should not be the sole determining factor, it’s important to consider the value you will receive in terms of the quality, accuracy, and professionalism of the valuation report.
- Communication and collaboration: Evaluate the provider's communication style. Are they willing to collaborate with your team? A good valuation provider is responsive, transparent, and can explain complex valuation concepts in a clear and understandable way.
The importance of 409A valuations: final thoughts
When approaching a 409A valuation, we recommend you seek professional guidance from experienced valuation specialists or certified appraisers. When you choose experts like Cadre Advisory, you’ll have the expertise you need to navigate the intricacies of the valuation process and to create a defensible valuation that can withstand IRS scrutiny.
Additionally, carrying out regular 409A valuations is essential, especially as your company grows, hits significant milestones, or the capital structure changes. By keeping valuations up to date, your equity compensation plans remain fair and accurate, reflecting the true value of your company's stock.
A note from our lawyers
This post is intended to explain the generic background to a Section 409A valuation. It is not intended to provide specific advice for any business.
To understand the 409A valuation requirements and liabilities for your company, we recommend you seek qualified, independent advice.
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