Nonqualified deferred compensation can be a confusing legal and financial topic for your company. As described by IRS section 409A, this is compensation that workers earn in one year, but that is paid in a future year.
And planning for it is a headache for any entrepreneur lacking extensive experience in startup valuations. Fortunately, there are a few things you can do to make section 409A more approachable, and make managing your valuations a simpler, less headache-inducing process.
409A in a nutshell
409A is the system that applies to nonqualified deferred compensation. This is the technical term that distinguishes this type of compensation from from compensation tied to elective deferrals for retirement 401(k) or 403(b) plans.
For practical purposes, 409A can refer to things like stock options, stock appreciation rights or other forms of compensation typically associated with startups. To comply with the corporate tax code, then, you'll need to accurately value your company, update that value every 12 months (or after significant events that change the value of your company) and be aware of the penalties associated with non-compliance.
The demands of a valuation
To remain in compliance with 409A, your valuation needs to be a "reasonable application of a reasonable valuation method." There's more than a little ambiguity in this statement, so let's define exactly what you need here. For public companies, a valuation is relatively easy, but for private companies, things get trickier (as there's no stock price to dictate your market value).
You'll need to consider at least the following elements:
- All assets. This includes all your company's tangible and intangible assets, as well as the present value of future cash flows. Look at things like your equipment, intellectual property and investments.
- Comparable businesses. Take a look at your competitors and see how they're valued. Your business is unique, but you can at least get a ballpark figure for what you're worth by looking at your close competition.
- Control, liquidity and other factors. You'll also need to consider peripheral factors that could influence your company's value, including its marketability, liquidity and specific control.
If your fair market value comes into question for any reason, the IRS must prove that the efforts you took to calculate it were "grossly unreasonable."
How to effectively handle 409A valuations
If all that sounds somewhat complicated, it can be. Fortunately, there are a few steps you can take to simplify your life:
- Consider using specialized 409A software. For starters, you could use a service like eShares, which combines software and services from expert human analysts, to calculate your startup's valuation quickly. It will also be able to update your valuation in response to significant events, and produce written reports and document exactly how the valuation was created (in the event of an audit). If you're new to valuations and want the simplest solution, this is probably your best bet.
- Consider hiring an appraisal firm or professional appraiser. You may also consider working with an individual to appraise your firm. For this, you can use anyone with significant financial credentials (such as ASA, ABV, CBA, CVA, or CFA), or rely on someone with extensive experience in valuations, such as a venture capitalist or angel investor.
- Be aware of "material events." You'll need to update your valuation at least once every 12 months, and at every "material event" that significantly changes your company's value. These might be new rounds of funding, new leadership, new partnerships or the acquisition of new assets. Stay on top of your company's evolution.
- Understand the repercussions. For employers, nonqualified deferred compensation doesn't come with much risk; it's taxed as if it were regular income. However, if your company fails to manage 409A valuations properly, your employees could be personally liable for a 20 percent penalty tax, as well as potential interest payments for any taxes owed. In addition, if you don't perform a valuation, or don't consider all important factors when making your valuation (considered to be "grossly unreasonable"), your startup could fail an external audit.
If you're a new startup with hardly any assets, it's possible that your company could be valued at zero dollars, but it's still important to go through the formal process of valuation and have a written report on file to document how you came to that conclusion. For most companies, 409A valuations are a pain, but they're necessary if you're issuing common stock, stock options or any other form of non-qualified deferred compensation.