The term “safe harbor” evokes images of a boat resting peacefully, safe from rough seas and unforeseen danger.
In the world of 409A valuations, the boat is your business, the rough seas are IRS audits, and the safe harbor is being legally compliant one of four ways—most often by using a third-party valuation provider.
In this article:
First, to understand what a 409A valuation safe harbor is, let’s look at why IRC 409A exists in the first place.
The story of Section 409A begins as all good tax requirements do, with abuse of the existing system.
Never wanting to miss out on what’s owed, the IRS took action to regulate deferred compensation plans. They introduced Section 409A as part of the American Jobs Creation Act of 2004.
As an extension of that, anytime a company offers stock to their employees, they must adhere to strict guidelines on company valuation and distribution or risk severe tax penalties to their employees.
This just goes to show how seriously the IRS takes abuse of the system—which is why securing a 409a valuation safe harbor is so important.
Getting “safe harbor” means your 409A valuation is protected from liability or penalty from the IRS.
You achieve it by meeting certain conditions (discussed in depth below) and once you’ve got it, if the IRS challenges your valuation the onus is on them to prove it’s unreasonable.
When a company has secured a 409A valuation safe harbor, their valuation is accepted as fair and reasonable.
It’s most useful in safeguarding you from the hassle and headache of an IRS audit.
Let’s say the IRS wants to audit you. If you have safe harbor status, the onus is on the IRS to prove your 409A valuation is unreasonable.
Without safe harbor, it’s the company who is responsible for proving they followed reasonable methods and offered common stock at fair market value.
At a glance, 409A valuation safe harbors are important for two key reasons:
While the IRS hasn’t seriously investigated 409A valuations or penalized anyone for lack of compliance, the threat of it looms and no one wants to be the business they make an example of.
Securing safe harbor can be as simple and robust as hiring an independent third party to do the 409A valuation on your behalf or as complicated and highly scrutinized as applying specific formulas in-house.
My top three tips for achieving safe harbor status quickly, securely, and with minimal involvement and liability on your end is to:
Some SaaS companies offering valuation services, among other services, might not actually sign their valuations, casting doubt on their independence and the reliability of their reports in providing the safe harbor. This could leave clients vulnerable to IRS scrutiny regarding safe harbor validity. Essentially, without guaranteed safe harbor, the entire purpose of undergoing the valuation process is undermined.
Below I’ve outlined all four routes you can take to secure a 409A valuation safe harbor with details on when they can be used and how reliable they are.
Expand each of the presumptions below to learn about how they work.
As I’ve already stated, hiring an independent third-party 409A valuation provider is by far the easiest, most reliable path to safe harbor.
It’s also the most common.
How it works: You hire a qualified independent appraiser to conduct the 409A valuation such as Eton. Their valuation is then presumed to be reasonable. Should the IRS wish to challenge that presumption, they must have substantial evidence the valuation was grossly unreasonable.
Suitable for: It is most suitable for companies who want the highest degree of certainty in their 409A valuation.
Advantages: High confidence in IRS acceptance; provides strong protection in audits.
Considerations: It can be costly depending on the 409A valuation consultant chosen.
For a better understanding of what you can expect to spend, read our 409A valuation costs article
How it works: This presumption is for start-ups that are less than 10 years old, are not publicly traded, and do not anticipate a change in control or public offering within 12 months. The valuation must be performed by someone with significant knowledge and experience or training in performing similar valuations.
Suitable for: This route can only be used by early-stage startups less than 10 years old with limited financial history. It’s not one we recommend because the likelihood of having someone in-house with the expertise required is small.
Advantages: It can be more cost-effective.
Considerations: The individual performing the valuation must meet certain experience criteria. This method is subject to more scrutiny compared to an independent appraisal.
How it works: This method involves using an internal formula for valuation, often based on a multiple of earnings or other financial metrics. The formula must be consistently applied for other corporate purposes.
Suitable for: Can be used by companies that regularly use such a formula for other business valuations, like buy-sell agreements.
Advantages: It can provide consistency across business valuations.
Considerations: The formula must be reasonable and justifiable; there’s a risk if the formula becomes outdated or does not reflect current market conditions.
This is the least common path taken to safe harbor because it is the least reliable and most complex to follow.
How it works: To use this method, the company’s stock value must be determined based on specific rules known as a nonlapse restriction, often found in a ‘buy/sell agreement.’ This means the stock can only be sold at a price set by a fixed formula.
This formula usually considers the book value of the company or a reasonable multiple of its earnings. Importantly, the company must use this same formula for all types of transactions, whether they are paying employees with stock or buying and selling their own stock.
Suitable for: This path is only available to a relatively small number of emerging growth companies.
Advantages: Useful for companies where such restrictions significantly affect stock value.
Considerations: This method can be complex and might require a detailed understanding of how restrictions impact value.
If you fail to achieve safe harbor status, then your valuation is not presumed compliant with IRS regulations for deferred compensation, including stock options.
Of course, if the IRS audits your 409A valuation then you put your company and your employees at risk of significant financial consequences.
Increased scrutiny and audit risk:
Without safe harbor protection, your valuation may be more closely scrutinized by the IRS. This could increase the likelihood of an audit, during which you would need to justify the valuation methods and conclusions.
Potential tax consequences for employees:
If the IRS determines that the stock options are undervalued, the employees who received them could face significant tax penalties. This includes immediate taxation on vested options, a 20% additional penalty tax, and interest charges.
Company reputation and legal risk:
A failed 409A valuation can have repercussions on your company’s reputation and can also affect employee morale and trust, especially if employees face unexpected tax liabilities. Employees negatively impacted could also sue the company for their inaccurately valued common stock and the tax implications that followed.
You may need to conduct a revaluation of your stock options. This could involve hiring a qualified independent appraiser to provide a new valuation that could be more defensible in the eyes of the IRS.
There are a few things that can disqualify your 409A valuation from safe harbor status.
That list may feel overwhelming, which is why I always recommend companies work with a provider who can give them confidence in the 409A valuation process they follow.
It’s not worth the effort of applying formulas and methods yourself when there are 409A providers out there who know the requirements inside out.
Of course, it has to be the right provider because not everyone who offers 409A valuation services can guarantee safe harbor. It is possible that the SaaS companies offering valuation in addition to software subscriptions may disqualify their clients from Safe Harbor.
If you want a provider who guarantees safe harbor and who has never lost an IRS audit, check out our 409A valuation services at Eton.
Related Read: Check out this Real 409A Valuation Report Sample
Yes, issuing a Simple Agreement for Future Equity (SAFE) can trigger the need for a 409A valuation, as it may affect the fair market value of the company’s stock.
Short-term deferrals, certain types of separation pay, specific types of stock options (like incentive stock options and employee purchase plans under Section 423), and certain minimal value fringe benefits are exempt from 409A valuation requirements.
Technically, you can issue stock options without a 409A valuation, but doing so increases the risk of non-compliance with IRS regulations and potential penalties for both the company and the employees receiving the options.
Schedule a free consultation meeting to discuss your valuation needs.