Both public and private companies regularly offer deferred compensation to their employees in the form of stock options and retirement plans. The open market determines the value of stock options for public companies. But private companies whose shares aren't publicly traded must rely on different methods to price stock options.

409A valuations determine the fair market value (FMV) of private companies' common stock. Although a company may perform its own valuation, doing so puts itself and its shareholders at risk of severe tax penalties. Thus, businesses turn to independent appraisers for "safe harbor" 409A valuations, which the IRS presumes valid by default.

The IRS grants safe harbor status to three distinct valuation methods. In the event of an audit, this status ensures that private companies need not defend their appraisal. Instead, the IRS must demonstrate safe harbor valuations to be "grossly unreasonable," a high burden of proof, before imposing penalties.

Safe Harbor via the Independent Appraisals Presumption

Hiring an independent appraisal company to conduct a 409A valuation is the easiest path to safe harbor and, therefore, the most common. Companies should look to reputable firms, like B. Riley, that rely on established valuation techniques to perform the appraisal.

It's essential to find a firm that's truly independent, as conflicts of interest can jeopardize the valuation's safe harbor status. Thus, companies should steer clear of appraisers with a vested interest in the valuation. If the IRS deems the valuation grossly unreasonable, penalties could double shareholders' tax obligations and consequently expose the company to litigation risks.

Safe Harbor via the Binding Formula Presumption

Companies that wish to keep appraisals in-house may still earn safe harbor by valuing their generally applicable repurchase formula. The company must use the same formula to value its stock for all binding agreements, both compensatory and non-compensatory.

Such formulas typically calculate value as a percentage of tangible benchmarks, commonly sales, net income, or EBITDA. Because the binding formula restricts companies from valuing their stock in other ways, most companies pursue alternative appraisal methods.

Safe Harbor via the Illiquid Start-up Presumption

The IRS provides start-ups with an additional valuation method that qualifies for safe harbor. The start-up must be reasonably certain that they will not file for an IPO within 180 days nor undergo a change in control within 90 days. Additionally, this presumption applies only to start-ups founded within 10 years of the valuation date.

If the company meets these criteria, any individual "with sufficient knowledge, experience, and skill in valuing illiquid stock of a start-up corporation" may conduct the appraisal. Such an individual may be an employee or a third party. Regardless of their employment status, they should have a minimum of five years of experience performing valuations or similar work.