Over the last decade, a growing number of companies have launched online capitalization table management platforms that make it easier for entrepreneurs to manage their employee stock options. Some of these platforms also offer online business valuation services to help companies that issue stock options comply with applicable rules under Internal Revenue Code Section 409A.

Companies need 409A valuations to help them set the exercise price for their stock options. While the 409A valuations offered by online platforms may seem like a great, inexpensive resource for startups and early stage companies, you should use them with extreme caution. Many of these platforms produce inherently flawed “black box” valuations that are not IRS compliant, which may expose you and your employees to tax penalties, expensive legal and professional fees, and reputational damage. They may also generate values that diminish the effectiveness of your stock options as an employee recruitment and retention tool.

IRS Requirements for 409A Valuations

The IRS states that a 409A valuation is valid as long as it meets their definition of a “qualified appraisal”. According to IRC Section 170(f)(11)(E), a qualified appraisal is one that is conducted by a qualified appraiser in accordance with generally accepted appraisal standards.¹ A qualified appraiser is an individual that has earned an appraisal designation from a recognized professional appraiser organization and regularly performs appraisals for which the individual receives compensation.²

If the IRS determines that your valuation did not meet its definition of a qualified appraisal, or it disagrees with the appraiser’s analysis, it may choose to challenge the valuation. That is, the IRS may perform its own analysis to determine whether you issued stock options at an exercise price below fair market value.

So why is the IRS concerned with the exercise price of stock options? Stock options issued at an exercise price below fair market value could theoretically be exercised immediately for a gain and are therefore taxed differently than other forms of deferred compensation. The penalties outlined under Section 409A are in place to prevent the abuse of deferred compensation arrangements, a central issue in a large number of corporate scandals in the late 1990s and early 2000s.

IRS challenges can result in significant legal and professional expenses, including the cost of hiring an independent valuation expert. If the IRS finds that you did issue stock options at an exercise price below fair market value, you and your employees could face tax consequences.

Do Valuations from Online Platforms Meet IRS Qualifications?

While some online capitalization table management platforms outsource their 409A valuations, others generate 409A valuations in-house. Valuations produced in-house by online service providers are sometimes called “black box” valuations because they often employ software that uses simple formulas and cookie-cutter templates to generate valuation reports based almost entirely on inputs of quantitative information (i.e., financial information).

However, many aspects of valuation require subjective thinking on the part of the appraiser, as well as the consideration of qualitative factors that impact value. Removing subjectivity from the valuation process essentially reduces the human role in valuation to inputting data into software. This process allows the company to offer 409A valuations at a very low cost with quicker turnarounds compared to valuation firms. Typically, black box valuations are generated with very little time and effort by someone with minimal valuation experience and therefore do not meet the IRS definition of “qualified”.

Inherent Problems of Black Box 409A Valuations

As part of the 409A valuation process, the appraiser must determine the per-share value of the class of stock for which the options are being issued. This is accomplished in part by applying one of several value allocation methods. The option pricing method (OPM) is the most commonly used black box value allocation method because it’s more objective and easily applied than alternative methods (which we explain further in our article Stock Options: Valuation & Tax Issues).

One issue with using the OPM is that it often generates a higher value than other methods, such as the PWERM.³ Additionally, some of the inputs and assumptions that are used in the OPM can be selected in a way that results in a higher value to ensure compliance with Section 409A. In fact, black box valuation providers are known to purposely apply the OPM using assumptions that they assume will lead to an artificially higher value since it is much easier and faster than determining the correct assumptions.

The other problem with black box valuations is that they incorporate the same methodologies on every valuation, without considering the unique aspects of the subject company. Often, different subject companies require the appraiser to add different weights to each valuation approach, or apply different methodologies in conjunction with the OPM. Applying the wrong methodologies in certain cases could lead to valuations that are below fair market value.

Think Ahead

Black box valuations are cheaper than those performed by independent certified business appraisers or valuation firms. However, they also employ a process and method that typically produces higher values, which makes stock options less valuable, diminishing their effectiveness as an employee recruitment and retention tool. Furthermore, black box valuation providers produce reports that may not meet the IRS’ requirements. Hiring an independent business appraiser may cost more in the short term, but they are typically able to apply methods that generate a more accurate value for stock options while ensuring you are in compliance with Section 409A. If the valuation comes in even just a few cents lower, the value of the stock option will become more valuable as the company grows and the short-term cost will be paid for in long-term gains.

Finally, as a precaution, we suggest consulting with your auditor before issuing stock options. Once you obtain a 409A valuation, have your auditor review the report to ensure that it is accurate and meets the requirements set forth by the IRS. Doing so may help you and your employees avoid harsh tax penalties and protect yourself from an IRS challenge.

¹ Appraisal standards include the Uniform Standards of Professional Appraisal Practice (USPAP), which is maintained by the Appraisal Standards Board, and the AICPA’s Statement on Standards for Valuation Services (SSVS).

² Professional appraiser designations include: Accredited Senior Appraiser (American Society of Appraisers); Chartered Financial Analyst (CFA Institute), Certified Business Appraiser (Institute of Business Appraisers), Accredited in Business Valuation (AICPA), Certified Valuation Analyst (NACVA)

³ PWERM often generates a lower value because it incorporates a more realistic probability distribution of future possible outcomes than other methods. The PWERM assigns a higher probability to failure scenarios to reflect the fact that the failure rate for start-ups is as high as 90%. In contrast, the OPM assumes that future possible outcomes are lognormally distributed. Additionally, the PWERM accounts for future financing rounds and their dilutive impact.

This document is for informational use only and may be outdated and/or no longer applicable. Nothing in this publication is intended to constitute legal, tax, or investment advice. There is no guarantee that any claims made will come to pass. The information contained herein has been obtained from sources believed to be reliable, but Mariner Capital Advisors does not warrant the accuracy of the information. Consult a financial, tax or legal professional for specific information related to your own situation.