IRS Code Section 409A and Valuation
Under IRS Code Section 409A, options granted by companies must be valued at their fair market values on the date of their granting.
Prior to 409A, boards were able to establish option prices assuming they employed reasonable methods. Now, valuations can be conducted by companies as before; however, if the IRS determines, after-the-fact, that option exercise prices are below fair market value, the burden will be on the go-it-alone company to prove that its stock valuation method was reasonable.
Given the teeth of 409A (20% additional tax on the optionee, regular income taxes and employment taxes, and possibly interest charges), do-it-yourself the old way is not really a viable option. What, then, are the choices for valuing options in the new world of Section 409A?
According to 409A, there are three ways to obtain the "presumption of reasonableness" for your option valuations - not in order of appearance in the Code.
Presumption 1 - Binding Formula. A valuation based on a binding formula used in a shareholder agreement would be considered to be fair market value if the stock is valued in the same manner for any other transfer of shares of the same or substantially similar class of stock. This would include all noncompensatory purposes requiring the stock to be valued - including regulatory filings, loan covenants, issuances to and repurchases of stock from other than "service providers" (those receiving options).
[Because of these restrictions, this option is not likely to be used frequently.]
Presumption 2 -- Illiquid Start-up Valuation. A valuation made "reasonably and in good faith" of an illiquid, start-up company can enjoy the presumption of reasonableness if it meets certain requirements, including:
- The valuation must be provided in a written report.
- The valuation takes into account the "basic valuation factors" noted in 409A, which include:
- The present value of expected future cash flows of the company.
- The value of tangible and intangible assets of the corporation.