Axiom Valuation provides custom valuation services for Section 409A valuations.

Section 409A Valuation

Nonqualified common stock options and some other types of nonqualified deferred compensation are subject to the new Section 409A requirements. Deferred compensation amounts under these plans are subject to inclusion in a recipient’s gross income unless the plan meets the section’s specified election and distribution requirement. One of the key exclusions is when the exercise price of nonqualified stock options is equal to or greater than the fair market value of the underlying stock as of the date of the option grant. This exclusion requirement dictates that the IRS provides guidance as to how private companies can establish the fair market value of their stock consistent with this Section 409A exclusion.

The IRS will accept a valuation of private company common stock, if done by "the reasonable application of any reasonable valuation method." These include:

1. the fair market value of tangible and intangible assets of the corporation;

2. the present value of future cash-flows; and

3. the market value of stock or equity interests in comparable companies.

The valuation may include other relevant factors, such as control premiums or discounts for lack of marketability, which is consistent with the standards laid out in IRS Revenue Ruling 59-60 regarding valuation of private companies. Again consistent with previous IRS valuation rulings, a valuation is considered reasonable if based on an appraisal by an independent appraiser as of a date that is within 12 months of the date for which the value is being determined. The IRS has also provided two other alternatives to an independent appraisal that are considered to meet the reasonable valuation test. One is a valuation of illiquid stock of a start up company by experienced personnel, which may include employees or directors of the company. It would appear that a board of directors or a committee of the board of directors of a start up company may do the valuation, where the board or committee is composed of experienced venture capitalists or private equity investors that have significant experience in valuing start up companies. There are several additional requirements for this type of valuation to be reasonable that are spelled out in the proposed regulations. The other is a valuation based upon certain types of formulas. Examples of the formula-based valuation method would be valuing the stock based on a multiple of sales or earnings, or book value. However, for a formula-based valuation to qualify under the proposed regulations, it must be consistently applied to all valuations of the stock. Based on the IRS and Treasury comments on this method in the October 4, 2005 Notice, this alternative valuation method will not be easily accepted by the government.