An Internal Revenue Code Section 409A (IRC 409A) fair market value report is used to determine the fair market value of privately held company's common stock for purposes of setting the exercise price of stock options. A valid IRC 409A valuation must be based on a reasonable and good faith determination of the fair market value of the stock and must comply with the requirements of IRC 409A.
However, circumstances can arise that render a valid IRC 409A fair market value report invalid. Some of these circumstances include:
Material changes in the company's financial or operating conditions: A material change in the company's financial or operating conditions, such as a significant decline in revenue or a change in management, can affect the fair market value of the company's stock and render the IRC 409A fair market value report invalid. A material change in a company's financial or operating conditions refers to a significant shift in the financial health or business operations of the company. Such changes can affect the fair market value of the company's stock, making the IRC 409A fair market value report outdated and no longer accurate. For example, if a company experiences a significant decline in revenue, it may indicate that the financial performance of the company is not as strong as previously thought. This can lead to a decrease in the stock price and, in turn, affect the fair market value of the company's stock. The IRC 409A fair market value report, which is used to determine the exercise price for stock options granted under an IRC 409A plan, may no longer accurately reflect the true value of the company's stock, rendering it invalid. Another example of a material change in a company's financial or operating conditions is a change in management. A change in the leadership of a company can lead to changes in the direction and strategy of the company, as well as changes in the performance and financial health of the company. This can affect the value of the company's stock and, again, render the IRC 409A fair market value report invalid.
Subsequent events that occur after the report was prepared and issued, such as a change in the company's business strategy or the discovery of new information that affects the value of the company, can render a IRC 409A fair market value report invalid. Subsequent events are those that occur after the preparation and issuance of a IRC 409A fair market value report. They can include a change in the company's business strategy, the discovery of new information that affects the value of the company, or any other event that may impact the fair market value of the company's stock. For example, if a company was planning to expand into a new market but later decides to pivot its business strategy to focus on a different area, this change in direction can affect the fair market value of the company's stock. In this case, the subsequent event would render the previous IRC 409A fair market value report invalid. Similarly, the discovery of new information that affects the value of the company can also render a IRC 409A fair market value report invalid. For example, if a company's financial performance unexpectedly declines due to a change in market conditions or a shift in consumer behavior, this could have a negative impact on the value of the company's stock and would require a new IRC 409A fair market value report to be prepared and issued.
The receipt of a term sheet for a financing does not necessarily render a IRC 409A fair market value (FMV) report invalid. However, if the term sheet has the potential to significantly impact the company's value (assuming it was accepted and the financing actually closed), it may be necessary to revise the FMV report to reflect the new information. If the term sheet is signed and accepted by the company's board of directors, the analysis and conclusions of the FMV report may be different. The acceptance of the term sheet indicates that the company has agreed to the financing round and its associated valuation, which may impact the FMV of the company's common stock. In this case, the FMV report should be updated to reflect the new valuation to ensure compliance with IRC 409A.
Periodic review and updates to IRC 409A fair market value reports are crucial to ensure compliance with the requirements of IRC 409A. The law requires that a fair market value determination must be made at least once every 12 months to ensure that the fair market value determination remains valid. If a IRC 409A fair market value conclusion is found to be invalid, not only may the company and its stock option recipients face penalties and taxes, but stock option recipients may also be unable to exercise their stock options. It is imperative for companies to keep their IRC 409A fair market value reports up-to-date to avoid potential consequences and stay in compliance with the regulations.
How can Eton help?
Eton Venture Services was founded by veteran Silicon Valley lawyers and includes a team of CPAs and CFAs who were trained by the ‘Big Four’. Valuation and valuation advisory is our sole focus, meaning that our experts are independent and unbiased, with no conflicts of interest. Our customized solutions, tailored reporting, and flexible pricing options ensure that private companies receive the highest level of service and value. Hundreds of companies have trusted Eton to provide rigorous, audit-defensible, and optimized IRC 409A and ASC 718 valuations to assist in attracting, retaining, and incentivizing top talent which remaining in compliance with the law.
Our team will work with you to ensure that your company's financial reporting is compliant and that your IRC 409A FMV report accurately reflects the fair market value of your common stock and any impact to it from a preferred stock financing. Join the industry leaders who have already experienced the advantages of Eton's exceptional client service and valuation expertise. Contact Eton Venture Services today.
