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Thursday, February 7, 2019

Going IPO? Be Mindful of Potential 409A Pitfalls


Managing your company’s obligations under Section 409A of the IRS Code (rules on deferred compensation for such payments as bonuses, severance packages and stock options) requires an extra measure of vigilance when you are reaching a valuation for your company. Here I discuss some of the key areas subject to critiques by auditors and the IRS.

When are 409A valuations most scrutinized?

An obvious event that requires auditors, the IRS and even the SEC to review or scrutinize your valuations is an IPO. When you are ready to file your S-1 your 409As become key indicators of your company’s historical value. Therefore, inadequately prepared 409A valuations will reflect poorly on your company and might raise questions into how prepared you actually are for an IPO.

Another time is when your 409A valuations are internally prepared by management. Not every company has the right internal resources for preparing a proper 409A, and when this happens such valuations will be examined more closely. Note that the IRS has indicated that it is giving extra scrutiny to 409A valuations done by management. Additionally, a full report needs to be written to be in compliance with IR Code Section 409A. An Excel spreadsheet will not suffice.

Even if you are not on the IPO track, the IRS still recommends that a 409A valuation be performed not less than annually; more often if a company achieves a major milestone that would change its value, such as a new round of financing or a major product development hurdle is met such as a successful tape out for a chip design company. Getting a 409A valuation done once a year is the suggested minimum for any company, while high-growth technology start-ups typically have 409As done every six months or so.

Another reason to have a 409A valuation performed by an independent qualified valuation specialist is that it is a safe harbor for the company with the IRS. Lack of a 409A valuation or a poorly done one can be a red flag for potential acquirers. We have heard of potential public company buyers losing interest in acquiring a privately held company because of potential issues with the IRS regarding lack of compliance with IR Code Section 409A.

Finally, when your company offers a grant with complex features such as a performance condition, more often than not your 409A valuation will need to incorporate more sophisticated methods of valuation. Auditors, especially those from the Big Four, are very strict regarding the use of methods that are robust enough to valuing complex awards such as performance awards and potentially where the preferred stock has down-round provisions and/or an anti-dilution clause.

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