As 2016 gets kicked off and many individuals and companies are readying their year-end financial statements and tax returns, it is important to remember that since 2014, the IRS has begun expanding its 409a audit program. Many companies are unsure of how rigorously to now comply with 409a given the relatively lower level of scrutiny 409a has been given historically. This has led to some companies opting for the “low-cost provider” valuations (in other words, cheap and poorly done valuations performed by unqualified appraisers) as documentation or even rolling the dice with no documentation at all. If a strike price is set below a company’s market value, the IRS might come knocking on the door. Conversely, if set too high, employees might not be happy as their upside would be less (although there is no regulatory risk with setting a strike price too high).
Like all things related to the IRS and taxes, the process of getting to a reasonable and supportable answer for a company is complicated, and the costs of a mistake are usually high. Think of 409a valuations as buying an insurance policy. Although the likelihood of being audited by the IRS in a given year is usually low, the cost of non-compliance can be significant to both the company and the individual receiving the grants.
One risk factor that is often overlooked is the impact on a potential liquidity event – either through the outright sale of the company or through an IPO. The merger and acquisition environment over the past several years has been robust and 409a valuations will often get scrutinized by potential buyers of companies during the due diligence process. If potential acquirers come across any valuations that look too low and could potentially cause an IRS problem, they can either back out of a deal or require the company to cancel and reissue options – which is costly and could delay transaction closing.
Further, the Securities and Exchange Commission (“SEC”) will look at prior issuances of company stock prior to an IPO and although the commission isn’t tasked with enforcing 409a, any appearance of “cheap stock” issuances will certainly raise an inquiry. When a company files for an IPO, the SEC heavily scrutinizes the company’s financial statements and if they find evidence that options may have been granted below fair market value, the IPO process will be much more difficult. A worst case scenario involves the cancellation and re-issuance of options along with a delayed IPO and financial consequences.
As a result of the increased IRS focus on 409a valuations, companies should be more prudent and take 409a as seriously as every other part of their tax compliance process. This means that proper planning and diligence (including the hiring of a qualified valuation firm such as GBQ) should now be a part of the equity-based compensation grant process. As the saying goes, an ounce of prevention is worth a pound of cure since once an audit has begun, corrections will generally not be accepted.