Last updated: 6 September 2024.
We live in a globalised business world where cross-border collaboration has become the norm.
The UK and US have always had strong business relationships, so it’s no surprise that UK companies have a natural synergy with US markets and employees.
The same is true in reverse - government stats show that some 1 in 20 UK employees work for US-owned businesses.
Like in the UK, the US also has a strong culture of employee ownership through option schemes and is one of a handful of countries that offer tax-advantaged share schemes like the UK’s Enterprise Management Incentive (EMI).
Offering stock options to your American team members boosts engagement and retention - and they aren’t limited by borders. However, it does mean you’ll have to comply with US tax regulations, including obtaining a 409A valuation.
Don’t worry - it’s actually pretty straightforward. Let’s dive in.
In short, the 409A valuation, named after Section 409A of the US Internal Revenue Service (IRS) Code, is a formal, independent appraisal of a company's common stock's Fair Market Value (FMV).
Company valuations like the 409A are crucial for determining the price at which businesses can offer stock options to employees.
Who is the IRS, you may ask? The IRS is the revenue service of the United States federal government, responsible for collecting taxes and administrating federal statutory tax law.
The IRS is equivalent to HMRC – and 409A valuations are broadly comparable to HMRC-approved valuations.
With that said, options in the US must be granted at a formally agreed FMV via the 409A, whereas businesses can ‘self-assess’ for the purposes of EMI options.
So, why is the 409A valuation a consideration for companies in the UK? For similar reasons as HMRC-approved valuations. The IRS introduced Section 409A regulations to prevent the underpricing of stock options, ensuring tax transparency and fairness.
Moreover, a valuation offers protection to stock option recipients through ‘safe harbour’ status. Without safe harbour status, the option holders would be subjected to immediate taxation and saddled with a 20% penalty.
Conversely, a legitimate 409A valuation ensures that, in the event of an IRS inquiry, the burden falls on the IRS to uncover any discrepancies in the valuation.
So this is definitely something worth getting right if you intend to offer options to US employees or taxpayers.
See our help page for more details.
Think of the process of granting EMI options to UK employees. Now, cast your mind across the pond to the USA. That process of granting any type of stock option to US taxpayers requires a similar type of valuation, but this time, it's called a 409A valuation.
There are some key differences - a 409A is similar to HMRC valuations but stays valid for 12 months instead of 90 days. However, if your company undergoes a material change impacting its fair market value (FMV) within this period - like a significant funding round - you'll need to revisit your 409A valuation.
So, when exactly does a UK company need a 409A valuation? Let's break it down:
There are two types of stock options in the USA: incentive stock options (ISOs) and non-qualified stock options (NSOs).
These differ primarily by how and when they're taxed. Like the UK’s EMI scheme, ISOs could qualify for special tax treatment. On the other hand, with NSOs, you usually have to pay taxes both when you exercise and sell.
In either case, when a UK company grants any type of stock options to its employees in the US, they need a 409A valuation. The IRS stipulates that stock options must be issued at Fair Market Value (FMV) to avoid potential tax penalties.
This broadens the spectrum and includes granting options to contractors, consultants, companies and subsidiaries based in the US.
These recipients, being US taxpayers, are subject to the same IRS rules and regulations pertaining to stock options.
As such, a 409A valuation is essential to establish the FMV of the company's common stock at the time the options are granted.
A UK company could employ people in the US and offer US options without establishing a business there.
However, when a UK company decides to establish operations in the US, it often creates a US-based subsidiary. This subsidiary is a separate legal entity that the parent company wholly owns.
While the US subsidiary and the UK parent company are part of the same overall corporate structure, they are distinct from a legal and financial perspective.
The company's value from a financial perspective is typically concentrated in the parent company, regardless of its location.
The parent company owns all of its subsidiaries, and therefore, the financial success and growth of these subsidiaries often translate into value for the parent company.
As a result, employees often prefer to have stock options in the parent company, as that's where the ultimate financial upside tends to be.
However, it’s worth highlighting that creating a US subsidiary doesn't mean that the US employees have to receive stock options from the UK parent company.
It could be that the US employees receive stock options in the US subsidiary, the UK parent company, or a combination of the two.
409A valuations should be undertaken by a third-party appraiser. This isn’t a legal requirement, but it places the onus on the IRS to disprove the accuracy of the valuation in the event of a dispute.
The IRS doesn’t set mandatory certifications for an appraiser to perform a 409A valuation, other than having “significant knowledge, experience, education and training.”
Here’s a blow-by-blow account of the process.
The initial stage of a 409A valuation is assembling all data required for the valuation, including:
This information parallels the data you require for an HMRC-approved valuation, offering a snapshot of the company's worth. However, 409A valuations are considerably more detailed.
Upon gathering all the necessary information, the appraiser determines the Fair Market Value (FMV) of the company's common stock.
The FMV is crucial in setting an appropriate exercise price for stock options. This reviews the company's financial health, market position, industry trends, risk factors and growth prospects.
The objective is to arrive at an accurate and defensible FMV that reflects the actual intrinsic value of the company's common stock, ensuring compliance with Section 09A regulations.
The final step in the 409A valuation process is creating the valuation report.
This report is a comprehensive document that encapsulates the entire valuation process, the assumptions made, the methodologies used, and the reasoning behind the determined FMV.
The valuation report is typically about 50 pages long and considerably more detailed than what’s required for HMRC-approved share schemes in the UK.
Most online sources quote the cost of a 409A valuation at somewhere between $2,000 and $5,000.
Vestd now offers 409A valuations at a fraction of the usual cost, ensuring that businesses who wish to offer options to US taxpayers can access an IRS-compliant valuation.
Offering stock options to your US employees is an excellent way to tap into the Ownership Effect and incentivise your team.
And whether you’re setting up a US-based subsidiary or simply wish to extend options to US team members and taxpayers, we've got your back.
While 409a valuations seem daunting, our deep experience of valuing startups for share schemes means we can readily produce what you need to gain an IRS-approved valuation.
Let's navigate this transatlantic journey together!