If your business offers stock options or other deferred compensation, a 409A valuation is required.
Understanding when it applies and how it works helps ensure compliance and avoid unnecessary risk.
Definition of Section 409A
A 409A valuation is required if you intend to offer any non-qualified deferred compensation plan to your employees in a privately owned company. The valuation must be performed before the first issuance of the compensation and at least every 12 months after that. A 409A valuation is a type of business valuation done to comply with IRS tax code 409A. It requires privately owned companies to assign value to deferred compensation, commonly obtained when start-ups offer stock options to employees as part of a funding plan or to attract talent at below-market compensation. The option is usually exercised more than 12 months from the award, therefore deferring income into the future.
Why a 409A Valuation Matters
A 409A valuation requires that fair market value of the shares be determined by a qualified professional. Unless a business owner has expertise in business valuation, it is best to hire a qualified individual to ensure the requirements of the code are met. Fair market value is defined as the amount at which a property would change hands between a willing buyer and a willing seller when both have reasonable knowledge and access to relevant facts, and neither is under compulsion to complete a transaction. A business valuation estimates value based on facts and circumstances of the individual business.
What to Consider In a 409A Valuation
To comply with 409A, a valuation must consider three standard approaches. While not specific to 409A, these approaches are standard in any business valuation engagement. There are other good reasons beyond the requirements of 409a to consider all approaches to valuation.
Asset-Based Approach
A general way to determine a value indication of a business’s assets and/or equity using one or more methods based directly on the value of the assets of the business less liabilities.
Income-Based Approach
A general way to determine a value indication of a business’s assets and/or equity using one or more methods wherein a value is determined by converting anticipated economic benefits into a present value.
Market-Based Approach
A general way to determine a value indication of a business’s assets and/or equity using one or more methods that compares the subject to similar investments that have been sold.
When a 409A Valuation Is Required
Section 409A valuations are valid for 12 months, requiring annual updates or updates for each additional round of funding. Once a business decides to offer stock options or other non-qualified deferred compensation to employees as part of their compensation plan, compliance with the code is required. While valuation engagements may seem expensive, they need to be budgeted as routine expenses to avoid IRS audits, penalties, and fines.
Why Planning for 409A Matters
Understanding the reasons for and requirements of 409A valuations and budgeting for them is essential if your company plans to offer employees non-qualified deferred compensation.