I’ll Be a Child of the Wind…At Least Until I Get a Retroactive 409A Valuation

by John Ludlum

Most private companies are now well aware that the valuation methods under Code Section 409A are for the purpose of granting Section 409A exempt “stock rights” which include employee stock options with a requirement, among others, that the options be granted at no less than fair market value on the date of grant. It has become a best practice to obtain a valuation from an outside independent valuation firm as soon as the company has sufficient funds as doing so allows the company to obtain a regulatory presumption that the valuation is reasonable providing a more certain tax compliance position. This makes sense given the severe penalties applicable to a “discount option” under Section 409A.

However, we still see some companies struggle with the timing of a Section 409A valuation where the valuation is received by the company on one date but has an earlier effective date. For Section 409A, if options were granted in the period before the valuation was received but after the valuation effective date, and if these options have an exercise price lower than the valuation price, these options will be out of compliance with the Section 409A fair market value on the date of grant requirement. For this reason, we recommend that no awards are granted while a valuation is pending.

Another interesting question – what impact does the Section 409A valuation have on determining the value of a company’s stock for other purposes? Payroll and income tax compliance requires a “fair market value” under Section 83 but does not require that a Section 409A valuation be used and instead draws from a long history of business valuation instruction from the IRS reaching back to Revenue Procedure 59-60. The factors considered by valuations for most purposes are similar, however, and the fair market value requirement under Section 83 includes requirements that the valuation be done in good faith and used consistently. Using inconsistent valuation methods for different purposes or for grants to different employees could suggest that the method is not a good faith attempt at determining the fair market value.

The concern is that the Section 409A valuation is typically the most rigorous valuation that a private company has. To the extent that it applies by its terms to a given time period, it would be hard to argue that the Section 409A valuation is not correct when another valuation is needed absent a clear problem with the Section 409A valuation (which would make it problematic for stock option grants). So while the stakes are lower for general tax purposes (income reporting and withholding) than they are for option grants under Section 409A because the tax consequences of losing a valuation challenge from the IRS are less harsh (no 20% excise tax), if the company has a Section 409A valuation that applies to the period in question, that would give the IRS a basis to challenge a different valuation used by the company for income tax purposes.