Qonversation on 409A Valuations

Written By:
Srikanth Prabhu
July 26, 2023

In a recent Qonversation on 409A Valuations, hosted by Amit Majumder, Head of SEA & ANZ at Qapita, with Evelyn Tay, Valuations and Financial Reporting at Qapita, they deep dive on what 409A valuations are, who it affects and how it affects them.  

409A Valuation determines the fair market value of the company's shares to ensure employees' stock options are priced accurately. Proper 409A valuation helps avoid tax penalties and legal issues. Enron’s, the infamous energy company that collapsed in 2001, \ fraudulent accounting practices brought attention to the importance of accurate financial reporting and fair valuations, including those related to employee stock options. After the Enron scandal, regulations like Section 409A were introduced to prevent similar abuses and ensure transparency in valuations and financial reporting for privately held companies.

Watch the full video here:

409A Valuation & Strike Price

The strike price for employee stock options is typically determined based on the 409A valuation of a company's common stock. The 409A valuation provides the fair market value (FMV) of the company's shares at a specific date. The strike price is usually set at or above this FMV to comply with tax regulations and avoid penalties.

When issuing stock options to employees, companies want to offer an incentive to employees while ensuring they don't run afoul of tax rules. Setting the strike price at or above the 409A valuation helps ensure that the options are not granted at a discount to the fair market value and, therefore, are less likely to trigger tax issues for the option holders.  

It's worth noting that the strike price can be adjusted over time as the company's valuation changes with subsequent 409A valuations. This allows companies to maintain compliance with tax regulations while continuing to incentivize employees with stock options.  

Evelyn also discusses a common misconception that only US companies must do 409A valuation is not true. While the requirement for 409A valuations stems from the US tax law (Section 409A of the Internal Revenue Code), it applies to both US and non-US companies that issue stock options or other deferred compensation to US-based employees.  

If a non-US company has US-based employees who receive stock options as part of their compensation, the company is still subject to Section 409A and must conduct 409A valuations to determine the fair market value of the stock options.

The key factor is the presence of US-based employees with stock-based compensation arrangements, regardless of where the company is incorporated or headquartered. This ensures that US tax laws are followed for these types of compensation arrangements, regardless of the company's location.

A 409A valuation should be conducted when a privately held company issues stock options or any deferred compensation to its employees. It is essential to perform the valuation before granting the stock options to ensure compliance with IRS regulations. Additionally, a 409A valuation should be updated regularly, typically at least once a year or upon significant events such as fundraising, M&A transactions, or major changes in the company's financials. Keeping the valuation up to date is crucial to provide accurate and defensible fair market values for the stock options and avoid potential tax penalties for both the company and its employees.  

Recommended Reading: 7 Things To Know About The 409A Valuations

The three common valuation methods are:

1. Market Approach: This method uses comparable market data, such as the prices of similar publicly traded companies or recent M&A transactions, to estimate the value of the subject company. This method helps companies in the earlier stages, allowing us to look at peer companies and evaluate comparative performance.  

2. Income Approach: This method assesses the present value of the company's future income or cash flow, considering factors like projected earnings, growth rates, and risk.  

3. Asset Approach: This method evaluates the company's net asset value by subtracting liabilities from the fair market value of its assets. It is suitable for asset-heavy businesses or when the company's value is primarily tied to its tangible assets.  

The live also discusses how the fair market value of ordinary shares and the fair value of ESOPs are introduced as two different ideas. The basic idea is that the former is just for ordinary shares whereas, for options, you have to do it for two different instruments.  

To go further into detail:

1. Fair Market Value of Ordinary Shares: This concept refers to the price at which a company's shares would be sold in an open and competitive market between willing buyers and sellers, with no compulsion to buy or sell. It is used for various purposes, such as determining the value of shares for tax purposes, financial reporting, mergers, and acquisitions.  

2. Fair Value of ESOPs: Employee Stock Options are a form of compensation given to employees, allowing them to purchase company shares at a predetermined price (the strike price) in the future. The fair value of ESOPs is specific to these stock options and represents their estimated worth at the grant date, considering factors like the company's current stock price, exercise price, expected volatility, time to expiration, dividends, and risk-free interest rate.

In summary, the fair market value of ordinary shares is a broader concept applicable to the entire company's shares, while the fair value of ESOPs is a specialized concept used for valuing stock options granted to employees as part of their compensation.

It is important to not make the common mistake of not realizing that your company needs a 409a valuation. Such companies often give out ESOPs at close to 0 exercise price, which is significantly under their fair market value and don’t realize till employees have to pay taxes. It basically can arise from not knowing enough about 409A valuations and the regulations surrounding it.

Srikanth Prabhu

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