409A Overview

Section 409A of the IRS code regulates nonqualified deferred compensation. Typically, this type of compensation is issued in the form of stock options. Section 409A requires that the strike price of these options be set at or above the fair market value (FMV) of common stock. For private companies—within which shares are not actively traded on an open market—a third-party valuation firm is usually hired to determine the value of common stock.

But what if I sell common stock? Doesn’t that transaction establish the value of the shares and therefore remove the need for a 409A valuation? It depends on the facts and circumstances of the transaction.

One challenge with relying upon a transaction of private shares is determining whether the transaction is an indication of FMV. Chapter 8 of the AICPA cheap stock guide, Inferring Value from Transactions in a Private Company’s Securities, provides the following flow chart for guidance in evaluating private company stock transactions.

As you can see, there are three essential questions in determining how secondaries should be used as an indication of value.

What Is an Orderly Transaction?

FASB ASC 820 defines an orderly transaction as

A transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).[1]

In private company financing situations, this definition is often satisfied, but that is not the case with secondary transactions. Circumstances that indicate the transaction was not orderly include:

Each of these circumstances focuses on situations in which the seller would usually be pressured to accept a price below FMV, but equally important is the need to assess whether the buyer had pressure to buy at a price higher than FMV. For example, perhaps an eager investor offered a premium over current FMV without a thorough analysis in order to gain early entry into a fast-growing start-up. Circumstances such as these should be determined not to exist before applying any weight to the transaction.

In determining whether a transaction is orderly, a good rule of thumb is to assume it is orderly until proven not orderly.

If the transaction of common stock under question doesn’t have enough evidence to prove it was not orderly, then it can and should be taken into consideration when determining the FMV of the company’s common stock. After getting to this point, there is just one more hurdle. The final task is determining how much weight to apply to the transaction versus other indications of value.

Weighing the Transaction

Applying weight requires additional judgement. Industry trends suggest secondary transactions of private stock are less reliable when compared with other market indications of value and therefore should usually have little weight applied to them. This is due to the many hurdles discussed in this article. When weight should be applied, the AICPA provides several factors to help determine how much:

Conclusion

Section 409A of the IRS code has significant tax implications for companies issuing (and employees receiving) deferred stock compensation. A 409A valuation can help avoid unnecessary tax penalties. Determining whether a common stock transaction can be used in place of a 409A valuation may require significant judgment. Even when the transaction can be used as an indication of value, in most cases, other market indicators will need to be considered in tandem. When in doubt, the best decision is to enlist a reputable valuation firm to provide a 409A valuation. With that in hand, you and your auditors will be more confident the determined common share price is equal to fair market value.

This article is purely informative, and Scalar does not accept any responsibility for action taken based on the content of this article.

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[1] Statement of Financial Accounting Standards No. 157 Fair Value Measurements, Financial Accounting Standards Board, 8.