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409a Valuation Service

Valuations for IRC Section 409a for Employee Stock Ownership Plans

Today’s non-qualified deferred compensation plans (NQDC) are outlined in the IRC Section 409a with specific and measurable guidelines as to how such plans are designed, operated and administered. Such plans are typically paid by a “service recipient” to a “service provider” for tax purposes. The IRS requires regular Section 409a valuations of common stock included in NQDC. Failing to adhere strictly to Section 409a rules could result in immediate taxation, up to a 20% penalty and potential interest on top. In all, slipping up could be extremely detrimental to your pocketbook.


When corporations are cash poor, they frequently will shift to greater stock-based compensation. Doing so without understanding section 409a and the inherent tax consequences in the future may be penny wise and pound foolish.

Sarbanes Oxley requires a 409a valuation be performed to value stock options for employees in pre-publicly traded businesses. This is done for federal tax purposes and is often regularly performed in venture-backed start-ups where stock compensation is used to attract top talent. 409a valuations are required to be performed at regular intervals including every 12 months and when significant changes are made to the equity structure or equity compensation of the employees. For instance, anytime employees are given stock as compensation in non-publicly-traded companies, a 409a valuation should occur.

Accurately valuing stock options in these scenarios is essential as failing to do so may cost more in the long run for both you and potentially your employees.

Valuing stock options under Section 409a is performed using “reasonable application of reasonable valuation method.” In most cases, qualified third-party firms are hired to meet the 409a valuation rules, including the annual re-evaluation plus any new rounds of financing, new product launches, major customer acquisitions or employee hires.

Valuation Methods

Equity valuation for tax purposes is outlined in several prominent valuation models including AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation. The following provides a brief outlines of each of these methods and showcases how we best implement our valuation methodology to them.

Current Value Method

This method suggest value is a function of common equity value at the grant date of the stock. This form of value as if the company were to be valued and sold today. This method is certainly most relevant if the company were actually sold today, but it helps in providing a benchmark for valuing common equity for non-qualified deferred compensation plans.

Option Pricing Method (OPM)

Option pricing for common stock on the future net asset value of the company, given considerations for such things as senior debt/equity obligations, volatility of operations, time to scale and volatility of comparable companies. This method essentially looks at the value of the company’s equity given an expected investment horizon and expected volatility between now and then. The OPM method is particularly helpful when significant senior obligations are ahead of common stockholders or when it is reasonable to expect future growth in firm operating results.

Probability Weighted Expected Return Method (PWERM)

This method uses assumptions of discrete valuation outcomes of the company in the future. This methodology assumes multiple and various probability outcomes in the future given multiples potential sale scenarios. When future outcomes are abnormal or more unsure, this method helps to alleviate the potential for peaks and valleys in your valuation distribution and makes estimates that are reasonable given that future valuation assumption.

Individual company needs should be assessed in determining which valuation methodology would best suit their particular assumed outcomes. Finding a third party to assess and perform the 409a valuation shifts the burden of proof to the IRS. We provide 409a valuations for your Employee Stock Ownership Plan (ESOP). Contact us to learn more.

Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. Section 409A regulates the tax treatment of “nonqualified deferred compensation” paid by a corporate entity (“service recipient”) to all “service providers,” which includes executives, general employees, some independent contractors and board members. The effects of Section 409A are far reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt.

What does this mean to you? Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.