Just before an exit or IPO, tax authorities may challenge the 409A valuations to increase the tax liability. This is when issues can arise, potentially jeopardizing the deal. What are the risks, and how can they be avoided?
In the absence of regulation in the field of valuations, some entities offer services that should raise red flags for management, such as predetermined results, unusually low prices, or overly short timelines that do not allow for thorough work and future audit protection. While these services might meet immediate needs, they can be harmful in the long term. When a company is preparing for an exit or IPO, tax authorities may challenge these valuations to increase the tax liability. This can complicate and at worst, torpedo the deal. Therefore, before starting the valuation process, it is crucial to assess the appraiser’s reputation and ability to defend the work before boards of directors and leading CPA firms. Do the company’s advisors recommend contacting the appraiser or avoiding their services? Does the appraiser have certification and the ability to comply with the 409A rules? In a few years, when an exit is on the horizon, will there still be anyone to turn to?
What is Section 409A?
Section 409A is an American code that defines rules regarding employee compensation, including stock-based compensation. It is essentially the American equivalent of Israel’s Section 102, which requires the appointment of a trustee and a 24-month period from the date of option or share allocation for employees to benefit from tax advantages. Similarly, under 409A, employees can defer the tax event from the grant date to the exercise date of their options if certain conditions are met, primarily that the options are not granted at a discount. In simple terms, the exercise price must be at least equal to the Fair Market Value (FMV) of the company’s stock. For public companies, this is straightforward as the market price is quoted daily on an exchange. However, for private companies, a valuation is required. The US tax authorities provide some relief for private companies, allowing a valuation to be valid for 12 months for granting options, provided no material event has occurred. While a material event is not defined by law, common practice identifies events such as funding rounds, IPOs, and changes in business activity as material events.
How does one choose a methodology for valuing private companies for the purpose of 409A?
The valuation methodology should align with the company’s stage of development. For instance, if the company has recently completed a fundraising round, its value must be determined using the Option Pricing Model (OPM). When there is no relevant value indication but the company can provide a cash flow forecast, the Discounted Cash Flow (DCF) model can be used, where predicted cash flows by the company’s management significantly influence the valuation. If management cannot provide a multi-year cash flow forecast but the company has substantial revenues or profit, a valuation can be performed using the multiplier method, based on the values of comparable public companies with similar activities, revenues, EBITDA, net profit, and net financial debt. Even if a company does not meet these criteria, its value can still be estimated using alternative approaches such as the cost approach, which considers the amounts invested in the company thus far.
Why should Israeli companies be concerned with US tax laws?
For American companies, including American subsidiaries of Israeli companies, U.S. law governs the granting of options to employees. This law is equally relevant for Israeli companies granting options to employees subject to American law, including any US-based employees as well as any employees holding US citizenship (regardless of their location of residency or dual citizenship). Therefore, Israeli companies that wish to grant options to their employees must verify whether American law applies to any of their employees.
Can an Israeli company be exposed because it has American employees?
Israeli companies operate under Israeli law, so if one or more of the company’s employees are subject to American law, the tax liability falls on the employees themselves, not the company. The obligation to report is on the employee, and the company does not have a withholding tax obligation in this context. However, since employees of private companies typically cannot meet the requirements of American law—specifically, estimating the company’s fair value for tax purposes—virtually all companies handle this issue on their behalf.
How do you correct mistakes that were discovered retrospectively?
In some cases, companies that have granted options to their employees may retrospectively discover that an employee, such as one with dual citizenship, was granted options not in compliance with Section 409A rules. There are two distinct scenarios depending on when the mistake is discovered: if the mistake is discovered in the same tax year the options were granted, the correction involves adjusting the exercise price to comply with Section 409A rules, requiring the employee’s consent but no other complications. If the mistake is discovered in a different tax year, the options must be canceled and re-granted, or a repricing process must be undertaken. This process is relatively complex, so it is essential to consult a CPA or attorney who is an expert in American tax law to execute this.
Why would a company with a single American employee do a 409A valuation?
While the immediate use of valuations is to determine the exercise price of options granted to employees subject to American law, these valuations can later be used for the company’s financial statements. For instance, they can calculate the accounting expense for granting options to all employees, determine the value of financial instruments such as SAFEs, and assess the value of all types of the company’s preferred shares.
Should exercise prices be the same for Israeli and American employees?
American and Israeli law do not require options granted to American and Israeli employees to have the same exercise price. Israeli employees can receive options at any exercise price, including zero, while American employees must receive options at an exercise price equal to or higher than the market value of the company’s stock to comply with 409A rules. Granting with a discrepancy is a human resources issue only. In most companies, it is common to grant Israeli employees options at a zero exercise price during the initial stages. As substantial activity begins in the U.S., companies often standardize exercise prices for all employees because of internal HR reasons.
The problem of “Cheap Stock”
After a company enters the IPO process, which typically takes about a year and a half, the problem of “cheap stock” may arise. This issue occurs when options are granted to employees during the full year preceding the IPO at a significantly lower exercise price compared to the expected share value in the IPO. This is a critical issue when preparing the prospectus for the SEC. Towards the end of the offering process, shortly before the pricing stage, the company must deliver a “Cheap Stock letter” to the SEC, detailing the quarterly valuations and all grants made during this period.
The SEC will audit these valuations, scrutinizing the company’s assumptions in relation to the expected IPO value, the methodologies used, and any secondary transactions near the valuation date. They will also examine the methodology of the Discount for Lack of Marketability (DLOM) applied. The SEC expects a gradual convergence to a value slightly lower than the expected IPO value throughout the period. If the SEC does not approve the valuations, the company must retroactively amend the cost of the options in its financial statements. This scenario is undesirable as it is very costly and may tarnish the company’s reputation with tax authorities, a situation no company or its financiers want to face.
Therefore, it is highly recommended for companies in this period to perform quarterly valuations. Initiating this process proactively, rather than waiting for an auditor’s recommendation, is advisable. The recommendation is inevitable, but starting early brings advantages. Valuations take time, and the shorter the schedule for completing this task, the higher the likelihood of mistakes, not to mention increased costs.
Beyond the exercise price, compliance with the various criteria required under the rules of Section 409A is nuanced and raises many questions, some of which we have answered here. For any additional questions, you are welcome to contact Roni Birenzweig, Senior Analyst and Head of 409A Valuations at S Cube (roni@s-cube.co.il).
What is said in this article is provided for informational purposes only. The aforementioned does not constitute “investment consulting” and/or “investment marketing” as defined in the Law on the Regulation of the Practice of Investment Consulting, Investment Marketing and Investment Portfolio Management, 1995 and/or a substitute for the above and/or a substitute for legal, financial, taxation advice, financial or any professional and personal advice. The S-CUBE company and/or the IBI group and/or any of the group companies will not be responsible for any loss or damage caused to any third party due to reliance on the above information.