Safe harbor for your 409A valuation is a beautiful thing. It’s your source of protection in the case that the IRS chooses to audit your 409A, and, in contrast, can be a major headache if you don’t have it.
So now the question is, how do you get that coveted safe harbor protection?
In order to better explain this, let’s take a step back and talk about IRC 409A. 409A was introduced to the tax code back in 2005 to help the IRS establish better control over companies that offer deferred compensations plans. While this entails many things, we want to talk specifically about how it applies to stock options.
In short, to be compliant with 409A, the strike price of your stock options must be equal to the fair market value of your common stock at the time of issuance. This requires that your company receives a 409A valuation to determine the fair market value of your stock.
For an infographic and guide explaining everything 409A, be sure to check out our free comprehensive guide to 409A valuations.
Penalties for 409A noncompliance
Unfortunately, being found in violation of 409A has some undesirable consequences.
Let’s say that as a company you decide to issue stock options to one of your key employees. Without receiving any sort of valuation, you decide on a strike price that seems good and issue away. Your employee is happy and you’re happy, for now…
So what happens in the unlikely event that you are audited and found noncompliant? Let’s just say, it’s not pretty. To be found in violation of 409A means that the IRS can determine that you issued options with a strike price below fair market value. Here’s exactly what would happen:
- The employee that you issued the options to is immediately taxed for all of their vested options as part of their gross income tax
- On top of that tax, the employee must pay an additional penalty of 20%
- If that’s not bad enough, they can potentially be charged interest and other penalties
To make matters worse, it’s likely that the employee hasn’t exercised their options yet or sold their shares, so there’s the chance that they won’t have the cash to pay the tax, which could result in even more penalties.
No more happy employee.
To learn more about the consequences of 409A violation, click here.
Why is safe harbor so important?
So now that you’re aware of what 409A deals with and the penalties of noncompliance, let’s get back to the topic of safe harbor.
The term “safe harbor” was originally a naval term. A safe harbor is a place where your ship is safe from the elements and, in time of war, enemy ships. It’s a place of protection. Likewise, when dealing with your 409A valuation, safe harbor offers you a wall of protection in case of audits.
Safe harbor guarantees:
- The IRS must accept the valuation as valid unless they can demonstrate that the valuation is “grossly unreasonable.”
- The burden of proof is on the IRS. Basically, you are innocent until proven guilty.
Having the burden of proof on the IRS in the case of an audit is especially helpful. They have to do the work and put forth the effort to prove that your valuation is grossly unreasonably. If you don’t have safe harbor, then you lose that protection. You are guilty until you prove yourself innocent.
How do I get safe harbor?
Luckily, when the IRS established IRC 409A they also provided several ways for a company to achieve a safe harbor valuation:
- Secure an internal valuation from a qualified individual (only valid in the case of an illiquid startup)
- Have the valuation done by a third party valuation firm
- Use a generally applicable repurchase formula
In this article, we will focus primarily on the first two safe-harbor options listed.
Option 1) Internal Valuation by a Qualified Individual
The first option is to have your 409A valuation done internally by a qualified individual. However, this option is a little more risky and has a few more rules to be considered valid. Both the company and the individual performing the valuation must meet several requirements, described below.
In order for a company to consider this option they must be considered an illiquid stock company. The company must meet the following qualifications:
- Less than 10 years old
- No publicly traded securities
- No stock granted that is subject to a put, call, or similar derivative
- No reasonable anticipation to be acquired within 90 days or go public within 180 days
Furthermore the individual performing the valuation must be considered a qualified individual. The IRS never established specific criteria as to what constitutes a qualified individual, but they did establish the following clarifications:
The qualified individual who performs the valuation should have at least 5 years experience in relevant areas such as business valuation, financial accounting, investment banking, private equity, secured lending, or other comparable experience. The valuation is often done by a CFO or board member.
There is a level of risk involved in this option, due to some ambiguity. Since the requirements aren’t very clear, there’s a chance that the IRS may determine that the resume of the individual who performed the valuation doesn’t really meet the standards of a “qualified individual”, which would take away the safe harbor protection. For example, does the individual have to have 5 years of strict business valuation work, or could the 5 years they worked as an accountant with some exposure to business valuation count?
However, if you’re confident that the individual and the company meet the requirements to have an internal valuation done, then go for it. This is definitely a cheaper option, and guarantees safe harbor if it is done correctly.
Option 2) Independent Third Party Valuation Firm
Another popular option is to have the valuation done by a third party valuation firm. This is a little more expensive but also the safest. So long as the firm follows consistent methodologies, you will receive safe harbor.
When getting your 409A valuation done by a third party firm, it is important to provide them with all the information necessary. This will help them calculate your correct valuation, and get the strike price as low as possible without making it too low to be dangerous. Check out our guide, “How to get the lowest strike price possible when working with 409A valuation firms”.
You will need to provide the valuation firm with the following accurate information:
- Financial Data–
- Historical and projected financial statements
- Capital Structure and ownership of the company–
- Cap table, options, warrants, etc
- Articles of incorporation describing the terms and rights of each class of stock
- Terms of debt and convertible debt
- Business Information–
- Business plan or investor pitch materials
- Risks and opportunities
- Research and analysis of the competition
- Other information–
- History of all transactions in company securities
- Disclosure of pending transactions
- Past 409A Valuations
Today 40% of startups are choosing a 409A + Cap Table software subscriptions, such as Shareworks Startup Edition. This allows for less work and time in gathering your data because the cap table software already keeps your cap table and other documents up to date. A startup edition 409A is also cheaper and always done by an independent valuation firm, which provides safe harbor protection.
The price for a 409A valuation by third party firms has decreased significantly since the early days of 409A. Many new firms have popped up and, depending on your financing rounds, you can get a valuation done for anywhere from $1,200 to $5,000.
Finally, one of the biggest perks of having a legitimate third party valuation firm perform your 409A valuation is having them on your side. In the case of an audit, you will have double protection. First, the burden of proof is on the IRS. Second, a good valuation firm will defend you. They want to protect their clients as well as their own good name.
Get our guide for finding the right 409A valuation firm. 409A Valuations: 6 Questions to Ask a Valuation Firm Before You Sign On With Them
Warning About Nonindependent Valuation Firms
Warning! Watch out for cap table software companies who perform the 409A valuation in-house rather than partner with an independent third-party firm. These do not provide safe harbor.
Examples of this include software companies that try to appear independent by putting their valuation arm in an LLC or other entity that they still own.
For an independent valuation firm to maintain it’s “independence” they cannot provide you with any other services in addition to their valuation work.
The IRS identified what it takes to be independent and qualify for safe harbor in its business valuation guidelines. The guidelines require that “valuators will employ independent and objective judgment in reaching conclusions and will decide all matters on their merits, free from bias, advocacy, and conflicts of interest.“
A conflict of interest is a problem that arises when one party has multiple interests which could possibly corrupt its motives. In legal terms, an “interest” generally means some economic benefit.
The IRS also requires the valuation firm to attest that it “has no interest in the [company] that is the subject of the report.” Also, the IRS requires that firm attest that its “compensation is not contingent on an action or event resulting from the analyses, opinions, or conclusions in, or the use of, [the] report.”
- If a cap table management company receives an ongoing revenue stream for non-valuation services, it has big conflicts of interest.
- If a cap table management company also offers liquidity of the very shares it is valuing, there is an even bigger conflict of interest.
Does this remind you of Arthur Andersen and Enron in the early 2000s? It should. Arthur Andersen claimed to be Enron’s independent auditor but it was receiving much bigger fees by selling Enron consulting services. Some cap table management companies offer a low-quality, automated valuation for next to nothing. The reason they do this is because they can make more money selling the company cap table management software.
This relationship is an obvious conflict of interest.
It gets worse because the cap table management software company cannot claim that its compensation is unrelated to the use of the report.
The valuation report helps cap table management clients issue stock options. The cap table management company is compensated as clients use their software to issue those very options.
Some of these platforms even claim to help you buy and sell shares. So your cap table management vendor would have to claim independence where it is actually pricing an asset it is helping you to sell!
In short, it is unlikely that you will achieve safe harbor if your valuation report is signed by a cap table management company or one of its sister companies that offers “in-house” valuation services. We are careful to partner with independent 3rd parties (who we do not own) for this very reason.
So you’ve done your valuation and you’ve followed the guidelines to receive safe harbor. You now have a valuation of your company and you’re able to safely issue options using the strike price determined by the valuation. So are you completely safe now with no need to worry?
Generally, yes. Good job! However, there are a few things you still need to be aware of.
1) First of all, your valuation is only good for 12 months. If you plan to issue options more than 12 months after your valuation then you will need another valuation at that time.
2) Your valuation becomes invalid if there is a material change in your company that would affect the value of the company, such as:
- a subsequent financing round at a higher price per share
- an acquisition or the development of new and valuable IP
If this is the case, you must get another valuation.
3) Finally, remember that even though you have safe harbor, the IRS could still determine that your valuation is grossly unreasonable. Make sure that you do everything possible to facilitate as accurate a valuation as possible. Be very upfront with your valuation firm to give them all the correct information that they need and don’t hide any pending transactions that could alter your valuation.
409A compliance is important. Although it can seem like a pain, it’s worth it to protect yourself from the nasty consequences. Achieving safe harbor is your safest way to protect yourself in the case of an audit. We’ve addressed several ways to achieve safe harbor so make sure you pick the right option for your company.
If safe harbor isn’t important to you, you can use our free 409A valuation tool. This tool provides a quick way for you to perform your own valuation. Make sure you read the instructions and conditions of performing your own valuation or you could be playing in dangerous water.
Finally, be sure to check out Shareworks Startup Edition 409A valuations. We can help gather all your data and hook you up with one of our own 409A valuation firms that we partner with. You will receive safe harbor at a cheaper price than usual and we will walk you through all the steps.