Guide
The three 409A safe harbours, and what each one demands
Updated
The regulations do not require a valuation. They set out three ways to determine fair market value that are presumed reasonable, and you decide whether to be inside one.
Question 1
What are you granting?
Section 409A bites on stock rights whose exercise price is below the fair market value of the underlying stock on the grant date. Not every equity award raises the question.
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What a presumption is worth
Inside a safe harbour, the burden is on the IRS. The Commissioner may rebut the presumption only by showing the valuation method or its application was grossly unreasonable.
Outside one, the burden runs the other way and the standard is ordinary reasonableness rather than gross unreasonableness. That is the entire commercial argument for a 409A valuation, and it is worth stating plainly because the fee is usually justified to a board on the wrong grounds.
Independent appraisal
A valuation of a class of stock determined by an independent appraisal meeting section 401(a)(28)(C) and the regulations. It must be as of a date no more than 12 months before the relevant transaction it is applied to.
Two words carry it. Independent, which is what an internal estimate cannot be however carefully prepared. And the twelve months, which is measured to the transaction, meaning the grant, rather than to the anniversary of the last appraisal.
The illiquid start-up presumption
A valuation made reasonably and in good faith and evidenced by a written report, of illiquid stock of a start-up corporation. The conditions are cumulative.
The corporation and any predecessor have conducted no material trade or business for 10 years or more. No class of equity is traded on an established securities market. No put or call rights apply, bar a right of first refusal on an offer. No change in control is reasonably anticipated within 90 days, nor a public offering within 180 days.
The valuer condition is separate and objective: significant knowledge, experience, education or training. Significant experience generally means at least five years of relevant experience in business valuation, appraisal, financial accounting, investment banking, private equity, secured lending or comparable work.
The formula method
A valuation based on a formula that would be treated as fair market value under the non-lapse restriction rules. It applies consistently for that class of stock to all transfers to the issuer or to a more than ten percent owner, compensatory or otherwise. The exception is an arm's length transaction involving the sale of substantially all the outstanding stock.
The consistency condition is the whole difficulty. It covers every relevant share transaction, not only option grants. A company that prices buybacks differently has lost the presumption for the grants too.
Which condition breaks first
For most companies on the start-up presumption, it is the anticipation conditions rather than the ten years. A sale conversation that becomes real inside 90 days, or a public offering inside 180, ends the presumption. That happens while the valuation is still fresh and grants are still made against it.
For companies on an appraisal, it is the material event. A priced round changes the answer, and continuing to grant against a pre-round valuation is applying a method to facts it did not consider. Refresh on the earlier of twelve months and the next material event.