What is a 409A valuation & do I need one for RSUs?
Updated: Feb 15
A common and important question for founders and owners that are using Restricted Stock Units (RSUs) as compensation is, “Do I need to do expensive and time-consuming 409A valuations?”
The short answer, for private companies, is simply no. If you are using RSUs with double trigger vesting, you won’t have to do 409As when promising RSUs as a part of compensation. If you use the older single trigger vesting style of RSUs, you may need to do a 409A when the workers’ shares vest. At Upstock, for private companies, we advocate for the use of double-trigger RSUs because of the many benefits they have over stock options and single trigger RSUs.
Understanding the background details to this question is difficult because of the ever-changing nature of equity instruments. You cannot easily identify a fixed value for company equity at any given point in time. This is due to the fact that the value of a particular stock or equity grant may be shifting because of various market factors.
Still, we can make estimates and this is precisely what valuations are for. Valuations allow companies to operate with an informed perspective on how much a company, and its underlying shares, are worth.
Company valuations in general
For public companies, a valuation is relatively simple as the price of its shares is determined by how much each share is trading for on the stock market, also known as its fair market value (FMV). The difficulty lies in determining the FMV of private companies that don’t have stock market prices to rely on. That’s why an independent appraiser is usually required to calculate the FMV using established valuation methodologies.
There are several methods and approaches to getting to a company valuation. In general, they involve calculating the assets of the company and deducting the liabilities to come up with the company’s net value. Most appraisal methods also consider the company’s current earnings and cash flow. More advanced methods may take into account a company’s projected future cash flow and an “industry multiplier” which factors in the health of the industry that the business is operating in, including the prevailing economic environment, and related circumstances.
Valuations are not only desirable for information purposes, but they may also be necessary in order to comply with certain legal requirements. Some equity-based compensation, like stock options, require a valuation to determine its FMV and its cost basis for tax purposes. Under Section 409A of the Internal Revenue Code, a valuation may be necessary if you want your stock option plan to be exempted from the requirements and restrictive conditions of Section 409A.
But what is Section 409A in the first place and what are the legal and tax implications to equity-based compensation? Are restricted stock units (RSUs) covered? To answer this, there are some preliminary matters we need to cover.
A brief history of Section 409A
Section 409A of the Internal Revenue Code has been around for decades. The current version came to be with the passage of the American Jobs Creation Act in 2004. This federal tax act was partially made in response to the 2001 Enron scandal, where several high-level executives used various loopholes to hide huge financial losses and use their stock options to profit before the company’s eventual bankruptcy. Section 409A now regulates all types of deferred compensation and is aimed at preventing similar scandals in the future.
Deferred compensation defined
To be clear, the scope of Section 409A is not limited to stock options. All kinds of deferred compensation or income are covered. Deferred compensation is broadly defined as compensation in which a worker has a “legally binding right” to own something of value that is made payable in a later taxable year.
When applied to equity plans, the date of “vesting” is when this “legally binding right” is usually recognized because that is the time when the worker will receive payment of the award. For purposes of Section 409A, “deferred compensation” takes place when, instead of immediately paying or issuing the equity upon its vesting, it is paid in a later taxable year.
The necessity of valuation for tax purposes
So where does a valuation fit in all of these discussions? When you plan on compensating workers with equity—be it stock options, RSUs, or some other stock rights—you will still need to have it appraised for tax purposes at some point along the way.
The difference, however, lies in the timing and the purpose of the valuation. For stock options, a valuation should be done at the time of the grant in order for its strike or exercise price to be properly set at its FMV. Failure to do this would make the restrictions and requirements under Section 409A applicable and there may be tax penalties and other consequences. Ultimately, you want the tax authority to believe the earlier strike price down the road from the grant date.
On the other hand, RSUs are generally not considered deferred compensation under Section 409A as they are usually payable at the time they vest rather than the date they are granted. RSUs are a contract for future equity that only vests under certain conditions, also known as triggers.
Here’s a super technical fact that could be useful to know for some individuals. Some types of equity plans may also provide for vested RSUs to be paid at a later date but may nonetheless be exempted from Section 409A by utilizing the so-called “short-term deferral” exception; that is, payment is deferred no later than the 15th day of the third month of the next taxable year. So if the RSUs vest in November 2021 and are made payable on March 14, 2022, it is not considered as deferred compensation and not subject to Section 409A for the year 2021.
This does not necessarily mean that RSUs do not require a valuation. It is in fact needed for tax purposes under Section 83 of the Internal Revenue Code. They just don’t need a valuation until the RSU actually vests, which is usually years later after the grant occurs. This can help newer companies save money early on, and pay for a valuation later when they’re more established with a reliable cash flow. Moreover, if your RSU plan uses double-trigger vesting with the second trigger being a liquidity event like an acquisition or IPO, the price of the shares could be determined by the market so a valuation from an independent appraiser may no longer be necessary.
Valuations under Internal Revenue Code Section 83 versus Section 409A
When RSUs are vested (both triggers are reached) and finally paid, their FMV needs to be determined so the corresponding income tax can be calculated. In other words, a Section 83 valuation is made for the purpose of determining the FMV of the shares actually paid and delivered to the worker based on the vested RSUs.
In contrast, a Section 409A valuation for non-qualified stock options is required for the purpose of setting the strike price based on the stock’s FMV *at the time of the grant.* As mentioned before, failing to do this may result in the stock option plan being subjected to the exercise restrictions (death, disability, etc.) under Section 409A. More significantly, the person receiving the stock option (the optionee) gets the short end of the stick, as they may be liable for tax penalties.
Note that, with the exception of its stated purpose (and the safe harbor provision under Section 409A), a valuation made with either Section 83 or Section 409A in mind has no other significant difference. They both entail the valuation of a company’s shares based on sound and reasonable valuation methods.
RSUs do not require a Section 409A valuation since, unlike stock options, they have no strike or exercise price. A valuation should only be necessary under Section 83 for the purpose of determining the income tax due (based on their FMV) once the RSUs fully vest and are subsequently paid out or actually delivered to the awardee.
Upstock utilizes double-trigger vesting RSUs to do away with the problems associated with Section 409A and its numerous restrictions and requirements. Instead of having to do one or more 409A valuations per year, companies only need to perform a 409A when everyone’s RSUs fully vest upon a liquidity event. We believe that equity-based compensation for workers and employees should not be overly complicated and costly for companies and business owners. Our carefully crafted equity plans and award agreements are exempt from Section 409A and the slew of potential problems that might arise due to possible noncompliance.