What is a 409A?
409A refers to section 409A of the Internal Revenue Code in the United States. It sets out rules for nonqualified deferred compensation plans, which are arrangements between an employer and an employee to defer the receipt of compensation to a later year. The purpose of 409A is to ensure that deferred compensation is not used to manipulate taxable income.
Under 409A, nonqualified deferred compensation must be subject to a substantial risk of forfeiture and the timing and form of payment must be specified in advance. If these rules are not followed, the deferred compensation may be subject to substantial taxes and penalties.
409A can apply to a variety of arrangements, including stock options, stock appreciation rights, restricted stock units, and bonus plans. It is important for companies and individuals to carefully structure these arrangements to comply with 409A and avoid unwanted tax consequences.
What is a 409A valuation?
A 409A valuation is a process used to determine the fair market value of a company’s common stock for purposes of issuing stock options and other equity-based compensation to employees, consultants, and additional service providers. It is named after Section 409A of the Internal Revenue Code, which sets rules for nonqualified deferred compensation plans, including stock options.
The 409A valuation must be performed by a qualified independent appraiser and is required by the IRS to ensure that the stock options or other equity-based compensation are granted at fair market value. If the stock options are granted at a price below fair market value, the recipients may be subject to additional taxes and penalties.
The 409A valuation takes into account a variety of factors, including the company’s financial performance, growth prospects, market conditions, and comparable transactions. The resulting fair market value is used as the basis for determining the exercise price of stock options or other equity-based compensation.
Why 409a valuation is relevant for private companies?
A 409A valuation is important for companies because it is used to determine the fair market value of a company’s common stock. The IRS requires companies to have a 409A valuation to ensure that stock options and other equity-based compensation are granted at fair market value.
If a company grants stock options at a price lower than the fair market value the IRS can consider it a form of compensation, which may result in penalties and additional taxes for the employee and the company. Furthermore, if a company is acquired, the 409A valuation can impact the purchase price of the company and the payout for equity holders.
In summary, a 409A valuation helps a company to:
- Ensure compliance with IRS regulations
- Avoid tax penalties and additional taxes for employees and the company
- Set fair exercise prices for stock options and other equity-based compensation
- Determine the fair market value of the company’s common stock, which can impact future fundraising, mergers and acquisitions, and employee compensation.
Why might pre-IPO companies need to pay CLOSE attention to 409A?
Pre-IPO companies should pay close attention to Section 409A of the Internal Revenue Code because it governs the taxation of nonqualified deferred compensation. Nonqualified deferred compensation refers to compensation that is earned in one year but is paid in a future year, such as stock options, stock appreciation rights, and other equity-based compensation.
If a pre-IPO company offers nonqualified deferred compensation to its employees, it must be valued in accordance with 409A regulations to avoid severe tax consequences for both the employee and the company. Specifically, if the nonqualified deferred compensation is not valued correctly, the employee may be subject to immediate taxation on the compensation when it is earned, rather than when it is received. Additionally, the company may be subject to penalties and interest on any taxes that should have been withheld.
Therefore, pre-IPO companies should be careful to ensure that they comply with 409A regulations when valuing their nonqualified deferred compensation. This can be done by hiring an independent valuation firm to perform the valuation, establishing an internal valuation committee to oversee the process, or engaging legal and tax professionals with experience in 409A compliance. Failure to comply with 409A regulations can lead to significant financial and legal consequences for both the company and its employees.
Best practices for pre-IPO companies
- You shouldn’t perform a 409A in-house as the penalties of non-compliance aren’t worth the risk (although you can DIY)
- The IRS wants an independent 409A valuation from reputable firm that employs consistent, well-documented methodologies in their appraisals. This helps you achieve a safe harbor 409A valuation. (i.e. peace of mind–> which gives protection in case of an audit later)
- Make sure the appraiser has experience dealing with pre-IPO companies and knows your industry. You may need to provide robust discussions of the independent valuation firm in your registration statement or your SEC comment response letter. (e.g. their name, qualifications, whether the valuation firm is a related party)
- Be ready to provide the SEC staff with a detailed analysis regarding the process and substance behind your valuation determinations
Overall, pre-IPO companies need to be focused on growth, profitability, and transparency to attract investors and achieve a successful IPO.
How can Global Shares help?
At Global Shares, we can not only help you to design and launch your share plan — our team of dedicated communications specialists can help you create a bespoke communications package that’s tailored to your specific workforce needs.