Jul 26, 2023
Qonversation on 409A Valuations
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
The 409A valuation is an independent appraisal that defines the Fair Market Value (FMV) of the common stock of a private company. It is named after Section 409A of the US Internal Revenue Code (IRC) and plays a crucial role in setting the strike price for your stock options.
The 409A strike price is the set amount at which your employees can buy the company's shares as part of an Employee Stock Ownership Plan (ESOP). Understanding the relation between 409A valuation and the strike price will help you gather insights on tax implications, offer employee incentives and maintain transparency.
This blog discusses the need for companies to determine the strike price, the role of 409A valuation in setting the strike price, and how it affects the employees.
Unlike public companies, a private company’s valuation cannot be determined by examining the current market value of its common or preferred stock. This is where the need for a 409A valuation becomes apparent.
In addition to determining the FMV of your common stock, a 409A valuation also offers your enterprise a 'safe harbor' status. This status ensures that the valuation is considered reasonable unless the Internal Revenue Service (IRS) can prove it to be grossly unreasonable. Therefore, the burden of proof lies with the IRS before initiating any audits into your valuation.
As per the rules for the valuation methodology, you must get a 409A valuation from a qualified third-party appraiser or valuation firm before offering stock options to the employees. There are two more conditions to avail of a 409A safe harbor status for your enterprise:
The 409A valuation also ensures that the stock options reflect an accurate picture of your business. This transparency helps build trust with the employees, making your stock options an attractive part of their compensation package.
Strike price plays an important role in determining the potential value that your employees can gain from their stock options. A lower strike price makes exercising options more profitable for them, as the difference between the strike price and the fair market value of common shares represents their potential gain.
Here are some factors that make it important for you to determine the 409A strike price for new stock options.
The 409A strike price reflects the company's value at the time of granting the option. It is a snapshot of the company's worth, providing a benchmark for employees to assess the potential value of their stock options. By setting a strike price, you can offer a tangible measure of the opportunity being presented to your employees.
The 409A strike price plays an important role in boosting employee morale. When employees see the potential for the company's stock price to rise above the strike price, they are motivated to contribute to the company's success. The prospect of buying the stock at a lower price and potentially selling it at a higher price in the future can be a powerful driver of performance.
Section 409A of the IRC requires companies to set the strike price of stock options at or above the fair market value of a company share at the time of grant. This ensures that employees are not receiving an immediate tax advantage and protects your enterprise from potential penalties during an audit.
A 409A valuation provides an independent appraisal of the FMV of the common stock of your enterprise in compliance with US tax laws. The fair value defines the threshold for setting the strike price for stock options. It is not possible for you to offer options at a strike price below the FMV in your latest 409A valuation. This requirement is designed to ensure fairness and compliance with IRC rules.
Offering stock options at a 409A strike price lower than the FMV could be seen as providing immediate income to the option holder. This could trigger adverse tax consequences under Section 409A of the IRC.
Such noncompliance could lead to the income from these options being treated as deferred compensation, which becomes immediately taxable. This could attract a 20% penalty tax on the underpriced options in addition to the regular income taxes. Any interest on these tax deferrals may also be charged to the option holder.
The 409A strike price is a key feature of an options contract and helps determine the intrinsic value of an option. The value status of options, whether it is a call or a put, is defined by variation between the price of the underlying asset and the strike price.
A call option is a contract granting the buyer the right, though not the obligation, to purchase a specified quantity of an asset at a pre-determined price, also known as the strike price, during a defined period. Conversely, a put option provides the buyer the right, but not the requirement, to sell a specific amount of an asset at a pre-defined price within a given timeframe.
Before looking into the factors to consider when deciding on exercise options, it is important to understand the concepts of ‘Exercise Window’ and ‘Post-Termination Exercise Period’ (PTEP).
The 'Exercise Window' is the period during which a person can buy a number of shares at the 409A strike price. Options can be exercised only for a fixed period until they expire, which can be between seven to ten years if the person has been working with the company for that long.
A 'Post-Termination Exercise Period' (PTEP) refers to the amount of time an option holder has after termination to exercise their options. Many companies have a post-termination exercise period of three months due to the rules regarding how long an Incentive Stock Option (ISO) maintains its status post-termination.
However, there's no standard rule for how long a PTEP can last, and it depends entirely on your discretion.
Now that you understand the effect of 409A valuation on the strike price and the importance of the exercise window or options, here are the factors that employees should consider when deciding to exercise their options.
These refer to the prevailing trends and performance of the stock market. If the market is bullish, it might be a good time to exercise options. It is important to exercise due diligence here to maximize the benefits from the equity grants.
The company's prospects can significantly impact the value of its stock. Employees should consider the company's growth potential and stability before exercising the options.
Each employee has unique financial goals and obligations. The decision to exercise options should align with these personal financial priorities.
Exercising options can have tax consequences. It's important to understand these implications to avoid unexpected tax liabilities.
Options have an expiration date. The remaining time can impact the decision to exercise, especially if the options are nearing their expiration date.
An individual's financial health can influence the decision to exercise options. Factors like income, savings, and risk tolerance play a crucial role in this decision.
Employees need not pay taxes simply to receive stock options. The tax implications come into effect only when they exercise the options and purchase the stock at the pre-determined price.
Here is a detailed analysis of the effect of the type of stock options on taxation implications:
They are a type of employee stock option that offers favorable tax treatment. When ISOs are exercised, employees do not have to pay ordinary income tax. Instead, they are subject to capital gains tax when they sell the stock. This means that the profit from ISOs is taxed at the capital gains rate. This taxation percentage is generally lower than the ordinary income tax rate. However, exercising an ISO can trigger the Alternative Minimum Tax (AMT), depending on an individual's tax circumstances.
NSOs offer more flexibility but come with higher tax implications. When employees exercise an NSO, they are subject to income tax on the difference between FMV on the date of exercise and exercise price, known as the spread. When they sell at the current stock price, they report capital gains or losses for the difference between the tax basis and what they receive on the sale. It is important to note that with NSOs, you will withhold only some of the taxes, and it is up to the employee to pay the remainder to the IRS. This can often lead to unexpected tax liabilities for them.
The best option for your startup depends on your goals and resources. ISOs can be a powerful incentive for attracting and retaining top talent, but the tax benefits come with holding period restrictions. NSOs offer more freedom but may result in a higher tax burden for employees upon exercise.
Understanding how a 409A valuation determines the strike price assists you in ensuring regulatory compliance. This knowledge also helps with strategic decision-making, employee retention, and fundraising efforts.
Qapita can be your trusted partner in this journey. With an in-depth knowledge of the startup ecosystem and financial regulations in the US, Qapita provides accurate and reliable 409A valuations.
Choosing Qapita for your 409A valuation means choosing transparency, accuracy, and peace of mind. It means empowering your employees with fair equity compensation and paving the way for your startup's success.
Don't leave your 409A valuation to chance.
Connect with Qapita today and take the first step towards a successful equity journey.
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