25 Aug 409A Valuation Safe Harbor Guide (2019)
If you know what 409A Valuations are, you probably know that Safe Harbor for 409A Valuations are of the utmost importance. But just how important? In this blog post we’ll take a strategic look into the details of what a Safe Harbor 409A Valuation means, why it exists, and what’s at stake when you’re found in non-compliance.
To be honest, the penalties for 409A Valuation non-compliance are insane; hefty fines, irreversible reputation damage, and a potentially greater tax bill. But they are there for a reason. An inaccurate 409A Valuation can lead to another Enron. We all don’t want that. The IRS doesn’t want companies generating their own 409A Valuation because the likelihood of inaccuracies can by high. That is why there are Safe Harbor provisions for companies who obtain an 409A Valuation from third parties. It’s a win-win situation. The IRS doesn’t have to go through your 409A valuation with a magnifying glass, and in return, you get an accurate, non-biased value of your company. The Safe Harbor 409A Valuation is one of the best assets you can add to your company.
409A Safe Harbor Opportunities
IRS 409A Valuation (Link Here) has two opportunities for startups through which you can achieve a Safe Harbor 409A Valuation. If you meet the conditions of any of these three items, you are considered in “Safe Harbor”. Below is a description of each of the three opportunities:
Independent Appraisal
Binding Formula
Illiquid Startup Safe Harbor
Each of these opportunities are complex and unique. Each provides you with a clear path to achieving a Safe Harbor 409A Valuation. Let’s take a look at each:
Independent Appraisal Safe Harbor
When it comes to the matter of 409A Safe Harbor Valuations methods, the independent appraisal opportunity is among the most common and easiest to pursue. The IRS wants an independent 409A Valuation from a reputable firm that employs consistent, well-documented methodologies in their appraisals (like Five23). This is typically the easiest route to take in securing a Safe Harbor 409A Valuation. Find an independent, trustworthy valuation firm and pay them to do your 409A valuation. What’s so hard about that, right? Turns out, finding a quality fully-independent firm is more difficult than it seems.
Many companies turn to their cap table software providers for a 409A valuation package deal. This makes sense. Your cap table software has access to almost all the data you need to perform a safe harbor 409A valuation. However, even the leading cap table software providers stretch the boundaries on independence. And, in many cases you will run into a conflict of interest. Typically, your software provider doesn’t have the proper authority to provide you with an accurate 409A Valuation. They use old methods which do not require up-to-date financial data, which will eventually lead to an inaccurate 409A. If this is the case, you will find your valuation may be grossly mis-calculated. The IRS may find your company to be grossly mis-valued and take away your Safe Harbor exemption. At this stage you still may be on the hook for the inaccuracies.
Binding Formula Safe Harbor
The binding formula Safe Harbor applies to 409A Valuations based on the consistent use of one, generally-applicable repurchase formula in the company’s stock transfers. The legalese around this provision incomprehensible at best. The formula applies whether those transfers are compensatory or non-compensatory. It’s applied all of a company’s stock transfers and the stock transfers of at least 10% of the company’s shareholders. Additionally, the IRS specifies: any person or issuer holding more than 10% of the combined voting power across all classes of the issuer’s stock is void from this exception. Thus effectively making the provision unattainable for the vast majority of companies (any company which one shareholder owns 10%+ of the companies shares).
The big exception to the binding formula safe harbor presumption are “arm’s length transactions” related to the company’s stock. These are transactions for which both buyer and seller have no prior relationship and act independently of each other’s interests. The actual legislation covering this Safe Harbor presumption states that this generally-applicable formula should apply when used as part of a non-lapsing restrictions surrounding the company’s stock.
In essence, unless your company has a valuation of $100mm+ and more than 100 independent shareholders. You are not going to fall into this exemption opportunity.
Illiquid Startup Safe Harbor
The illiquid startup opportunity to Safe Harbor 409A Valuations is intended to accommodate the startup environment, where equity switches hands on a much more frequent basis. It applies only when both the service recipient and the service provider (typically the “employer” and “employee”, respectively) do not anticipate an IPO within 180 days or a change of control event within 90 days. A ‘Change of Control Event” could be a shift in voting power such that one person or entity holds more than 50%. It could be a liquidation; could be a substantial sale of assets; could be a board call. Point is, you’ll know it when you see it.
Under the illiquid startup presumption, your 409A Valuation must be performed by a “qualified individual”. The IRS specifies a qualified individual to be someone companies can reasonably rely upon based on some combination of knowledge, education, training, and experience (Five23 for example). They further specify this to mean five years of relevant experience.
Failing to Achieve a Safe Harbor 409A Valuation
As stated previously, you should view meeting 409A Safe Harbor requirements as a mandatory part of running your company. While it’s not actually required, the penalties of non-compliance aren’t worth the risk. Not even close. These penalties are exacted on each employee deferring compensation. The employees can be hit with a tax on their income, with the entire balance of their deferred compensation plan applied—for the current year and all past years for which their compensation was deferred. There’s a 20% excise tax on that. On top of that, the IRS charges interest on that 20%. That premium interest rate is roughly 1% plus the federal underpayment rate. Employees are hit with these tax penalties in tandem with whatever fees and fines they accrue in their efforts to pay off what they owe. Basically, get ready to pay a fortune to the government for failure to comply. Luckily, that is why there are Safe Harbor 409A Valuation, and they are cheaper and easier to get than you would imagine.
Safe Harbor 409A Valuation from Five23
At Five23, we pride ourselves on working closely with startups and investors to provide the best service possible. Our 409A Valuations are quick, straightforward, and painless. We give you a simple form to complete with minimal information required. From the time you start the process, we typically complete a 409A Valuation in just a matter of days. In addition, being an unbiased third party. We give provide the Safe Harbor 409A Valuation discussed in this article.
If you’d like to get started with a 409A Valuation, you can view our packages here (all come with a 409A Valuation). If you’d like to learn more about Five23, please visit our website or send us an email to: contact@five23.io. We’d love to hear from you.