409A Valuation Issues Q&A
Back on October 4, 2005, the IRS issued proposed regulations for Section 409A of the IRC. The proposed
regulations were intended to further explain how Section 409A applies to various compensatory arrangements,
including stock options granted by private companies. 409A is no longer a proposed regulation and has
officially taken effect January 1, 2009.
Does Section 409A apply to private company stock options?
Incentive Stock Options are exempt from Section 409A. Nonqualified Stock Options
are exempt from Section 409A if the following requirements are met:
• the option is granted with an exercise price
per share equal to or greater than the grant date fair market value per share of
the common stock subject to the option and at no point through the exercise date
of the option is the exercise price below the grant date fair market value;
• the number of shares subject to the option
must be fixed on the grant date of the option; and
• the option may not include any additional feature
for the deferral of compensation (other than deferral of recognition of income until
the award is exercised or vested). (Note, standard option grants generally do not
include any additional deferral features.)
Are incentive stock options subject to Section 409A?
Although Section 409A exempts incentive stock options, this exemption does not apply
if an amendment disqualifies the incentive stock option. Additionally, if
it is determined that the fair market value of the option price is greater than
the strike price at the date of grant, the option will not be exempted from 409A.
Therefore, the steps necessary for valuing a nonqualified stock option are also
applicable to incentive stock options.
Are any nonqualified stock options grandfathered from Section
Yes. Stock options are grandfathered from Section 409A if the option was vested
before January 1, 2005. The exemption will end if the stock option is materially
modified after October 3, 2004.
Are Limited Liability Company units subject to Section 409A?
Yes. Grants of partnership interest, options and appreciation rights in partnership
interests are treated in the same manner as grants of corporate stock, stock options
or SAR’s. (IRS Notice 2005-1)
As a private company, how do we determine the fair market value
of our common stock for purposes of these rules?
The regulations state that for the IRS to accept a valuation of private
company common stock, it must be done by “the reasonable application of any reasonable
valuation method.” Factors that the IRS states should be considered in the valuation
in order for the valuation method to be reasonable include:
• the value of tangible and intangible assets
of the corporation;
• the present value of future cash-flows;
• the market value of stock or equity interests
in similar corporations and other companies engaged in trades or businesses substantially
similar to those engaged in by the corporation being valued, the value of which
can be determined by objective means (such as through trading prices on an established
market or an amount paid in an arms length private transaction); and
• other relevant factors, such as control premiums
or discounts for lack of marketability and whether the valuation method is used
for other purposes that have a material economic effect on the service recipient,
its stockholders or its creditors.
The value must be determined taking into consideration all available information
material to the value of the corporation, and must be calculated as of a date that
is within 12 months of the date for which the valuation is being used.
Are there any valuation methods that will be presumed to be
Yes. While the foregoing “facts and circumstances” standard raises uncertainty,
the regulations provide three specific methods that the IRS will presume
to be reasonable if consistently applied: (1) an appraisal by an
as of a date that is within 12 months of the date for which the value is being determined;
(2) a valuation of illiquid stock of a start up company by experienced personnel
and (3) a valuation based upon certain types of formulas.
What is the “start up” valuation method?
To qualify as “illiquid stock” of a “start-up” company under the regulations,
the following requirements must be met:
• the valuation must be made reasonably and in
good faith and be evidenced by a written report that takes into account the relevant
valuation factors described above;
• the company (and its predecessors) cannot have
been in the active conduct of a business for ten years or more;
• the company cannot be public (i.e., it cannot
have any securities that are readily traded on an established securities market);
• there must not be any permanent put or call
on the stock or any permanent requirement that the company or any other person purchase
the stock (a right of first refusal or a repurchase right for unvested restricted
stock awards is permitted); and
• at the time of the valuation, it cannot reasonably
be anticipated that the company will undergo a change in control or an initial public
offering within 12 months after the valuation.
The person(s) performing the valuation of a “start-up” company must have significant
knowledge and experience or training in performing similar valuations. They may
be employees or directors of the company. In many instances, it would appear that
a board of directors or a committee of the board of directors of the start up company
may do the valuation, where the board or committee is composed of experienced venture
capitalists or private equity investors that have significant experience in valuing
start up companies.
What is the “formula-based” valuation method?
A formula-based valuation also will be presumed to be a reasonable valuation method
if certain requirements are met. Examples of the formula-based valuation method
would be valuing the stock based on a multiple of sales or earnings, or book value.
However, for a formula-based valuation to qualify under the regulations,
it must be consistently applied to all valuations of the stock. For example, the
formula value would have to be used for issuances to and repurchases by the company
from third parties and non-employees as well as for regulatory filings and loan
covenants. This appears to be a very restrictive method and we do not anticipate
many companies will be willing and able to qualify for this method.
How long will a valuation be valid?
All valuations under any of these methods are valid until the earlier of (i) 12
months from the valuation date or (ii) a material change in the value of the company.
Any method used must be applied consistently for all valuations.
How do these rules apply to stock options granted before January
In the regulations, Section 409A applies to all stock options that were
not vested prior to January 1, 2005. No distinction is made based on the grant date
of the option. However, on December 23, 2005, the IRS issued
Notice 2006-4 which provides interim guidance with respect to the application
of the new rules for non-qualified deferred compensation under Section 409A to stock
options granted by private companies. The guidance provides transitional relief
for private company stock options and the determination of fair market value and
is welcome news to private companies.
When did the regulations take effect?
The regulations were originally scheduled to take effect January 1, 2007
but IRS Notices extended effective date to
January 1, 2008, and then again to January
1, 2009. No more extensions were issued and 409A took effect on January 1, 2009