Any Port in a Storm? 409A: Safe Harbors

By Alex Hodgkin     Add your comments

The second in the series of articles about 409A compliance, this article explores the way to put the burden of proof of compliance back to the IRS.

At three hundred ninety-seven pages, Section 409A is incredibly lengthy and complex. However, it does outline some reasonably clear approaches that help when it comes to developing compensation policies that comply with its provisions. These presumptive methods, known as safe harbors, shift the burden of proof of noncompliance to the IRS, if, and only if, implemented properly. All that really means is that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the fair market value of the underlying security before it can claim any wrongdoing.

There are a number of these safe harbor methods, including: the illiquid start-up, binding formula, and independent appraisal approaches. The specifics of these various methods have been widely discussed and written about, and details about them can be found in a number of legal and accounting journals and articles. Suffice it to say here that, in order for any of the safe harbors to apply, the method must incorporate evaluation of a number of factors. These include: (i) the value of tangible and intangible assets of the company, (ii) the present value of future cash flows, (iii) the public trading price or private sale price of comparable companies, (iv) control premiums and discounts for lack of marketability, (v) whether the method is used for other purposes, and (v) whether all available information is taken into account in determining value.

Given 409a’s complexity and the harshness of the penalties for non-compliance, it is not at all surprising that many compensation professionals elect to employ the services of a third-party firm to perform valuations for regulatory purposes such as 409A. The basic, and generally not erroneous, belief is that an independent appraisal offers the most effective protection. However, even this poses its own challenges, since identifying competent professionals and understanding the standards to which 409A valuations will be held remain difficult. Why? Simple: There is no clear-cut and widely accepted definition of what or who constitutes a competent and capable valuation professional. Even though a number of professional organizations provide valuation training and credentials, there is yet no single universally accepted governing body.

Moreover, there is still a dearth of knowledge about 409A valuations themselves: on one hand, the valuation community itself has not created a robust body of knowledge concerning valuations performed for these purposes. And on the other, no companies have yet had to defend their 409A valuation conclusions in front of the IRS. Those cases will ultimately provide invaluable insights into how the IRS will prosecute 409A cases and what it will demand of those being prosecuted. With the end of the transitional period coming at the start of 2009, both those things should change.

Next article:Finding a Qualified Appraiser

Alex Hodgkin is one of the co-founders and managing directors of Arcstone Partners. Alex’s bio is readily viewable on website:

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