Internal Revenue Code Section 409A requires a business valuation for stock options, stock appreciation rights, and other forms of deferred compensation. Stock options issued below Fair Market Value (FMV) can result in adverse tax and accounting consequences. If the IRS determines a company has violated IRC Section 409A by issuing options below FMV, the option recipient may be liable for taxes on the value of the stock options plus a 20% penalty. In addition, the company may owe payroll taxes on the options.
Companies should perform a 409A business valuation at least annually. If the company experiences a significant event, such as a new round of financing, or if the company is approaching a significant value creation event, such as an IPO, more frequent valuations may be required.
The valuation of common stock also is used for GAAP financial reporting purposes. ASC 718 requires companies to record the expense associated with share-based compensation, which necessitates a business valuation. The annual business valuation is a valuable strategic planning tool that allows management to track changes in the company’s value drivers that impact overall value from year to year.