Start-up companies might not find conducting valuations early on as a cost-effective expense. But there are benefits both for companies and shareholders to address valuation concerns early in the start-up's lifecycle. Namely, obtaining an independent valuation before a company issues stock options helps avoid tax penalties that the Internal Revenue Service (IRS) may assess for failing to issue options at the appropriate fair market value. But also, independent valuations weigh strongly in the qualified small business stock (QSBS) analysis. Start-ups also face conflicting valuation issues—oftentimes they prefer a low valuation for employee equity grants but high values for the pre-money investment rounds to satisfy certain QSBS requirements.

409A Concerns

Pursuant to Internal Revenue Code (IRC) Section 409A, the exercise price of a stock option cannot be less than the fair market value of the stock underlying the option determined as of the date of grant. Treasury Regulation Section 1.409A-1(b)(5)(i). If this condition is met, the stock option is exempt from the harsh design and operational restrictions imposed under IRC Section 409A and avoids a nonqualified deferred compensation arrangement. If the document and operational requirements of IRC Section 409A are not met, there are potential adverse tax penalties to optionholders and employers, even for unintended violations. Penalties to the optionholder may include accelerated income tax recognition in the year of vesting (rather than on the exercise date), a 20% federal penalty tax, applicable state penalty tax, and interest.¹ In addition to the penalties and interest imposed on the optionholder, the IRS may require the employer or other service recipient to report the IRC Section 409A violation to the IRS, to withhold accelerated income tax, and to deposit penalties and interest. Although the IRS has provided self-correction programs for operational and document failures pursuant to IRS Notices 2008-113 and 2010-6, the professional fees associated with making these corrections could be substantial.

Start-ups have a strong interest to regularly obtain valuations to help ensure that options are granted with an exercise price equal to at least fair market value of the underlying shares. Such companies may rely on one of three safe harbor valuation methods for setting its fair market value pursuant to IRC Section 409A. Those safe harbors include: (1) independent appraisal method; (2) a formula-based valuation; (3) illiquid start-up method. See Treasury Regulation Section 1.409A-1(b)(5)(iv)(B)(2). The independent appraisal method is the most commonly applied safe harbor, which generally requires the valuation be determined by a qualified independent appraiser as of a date no more than 12 months before the date of the relevant transaction, i.e., a stock option grant. Treasury Regulation Section 1.409A-1(b)(5)(iv)(B)(2)(i).

While the regulations provide that a presumption of reasonableness applies if company stock is valued under one of the safe harbor methods, the IRS may rebut the presumption upon showing that the valuation method or application of such method was grossly unreasonable. Treasury Regulation Section 1.409A-1(b)(5)(iv)(B)(1), (2).

Key factors determining reasonableness include:

• A valuation method taking into account all available information material to the value of the corporation.
• A previously determined valuation cannot be used if such valuation does not reflect a later corporate event or if the value was calculated more than 12 months earlier than the date for which the valuation is being used.
• A consistent application of a particular valuation method to determine the value of its stock or assets for other purposes, including for purposes unrelated to compensation of service providers.

Stock options should be granted at a meeting of the Board of Directors paying specific attention to the determination of fair market value each time stock options are granted. Ultimately, valuations are critical and start-up companies should consider investing the time and cost in obtaining valuations to avoid unintended IRC Section 409A violations before granting stock options to employees and service providers.

Importance of Valuations for Qualified Small Business Stock

In order for a taxpayer to enjoy the $10 million or 10x basis QSBS exclusion benefits, IRC Section 1202(e) requires that for “substantially all” of a taxpayer’s holding period in the stock, at least 80% of the company’s assets by value must be used in the active conduct of a qualified trade or business. After the first two years of the company's formation, "working capital" equal to 50% of the company's value held in the company may be included in the 80% Test as used in the active conduct of a qualified trade or business (the "Working Capital Limitation"). This valuation requirement raises a separate set of concerns for founders and early employees of start-ups.

Unlike the 409A valuation (which the company has an incentive to discount where possible), pre-money valuations derived from financing rounds may reflect a more accurate representation of a company's arm's length values taking into account no discount. These higher arm's length values are critical for satisfying the Working Capital Limitation.

Example: LovableLawyers received 409A valuations representing putatively discounted values of $500,000 in year 3 and $1,000,000 in year 4, but had pre-money values of $2,000,000 in year 3, and $4,000,000 in year 4 in connection with Series A and B financing rounds. LovableLawyers had working capital of $400,000 in year 3 and $750,000 in year 4. Applying the values from the 409A valuations would not satisfy the working capital limitation in years 3 and 4, whereas applying the pre-money values would satisfy the working capital limitation for such years.

Without mindful planning, taint on the status of QSBS can be triggered inadvertently resulting in loss of QSBS benefits. Fortunately, the QSBS rules provide somewhat forgiving measures given the "substantially all" criteria. So a violation of the 80% active business test in a given period is not necessarily fatal for QSBS benefits.

But there are clearly conflicting valuation goals for start-ups issuing options that comply with IRC Section 409A, but also seeking to ensure that their shares meet the QSBS requirements. The tension is largely attributable to companies hoping for a low 409A valuation to grant their service providers stock options at a lower price and incentivize long-term wealth growth. Focusing narrowly on a low price per share disregards the risk of running afoul of the QSBS requirements.

Taxpayers with questions about company valuations or QSBS should contact Andrew Schmidt, or a member of the Hanson Bridgett Tax Group.

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¹ In California, a 5% penalty tax applies to non-compliance with IRC Section 409A. Section 17501(a) of the California Revenue and Taxation Code provides that "Subchapter D of Chapter 1 of Subtitle A of the Internal Revenue Code, relating to deferred compensation, shall apply, except as otherwise provided." Section 17508.2 to the California Revenue and Taxation Code substitutes "five percent" in lieu of the phrase "20 percent" in IRC Section 409A(a)(1)(B)(i)(II) and Section 409A(b)(5)(A)(ii).