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The Ticking Time Bomb in Startups’ Books

There’s often tension between a private tech firm and its accountants over 409A stock option valuations. If set too much below a company’s market value, the IRS might come calling. If set too high, employees might not be happy as their upside would be less.

But those tensions could surface more this year if a wave of acquisitions emerges, as some expect if the funding climate gets tougher. That’s because past 409A valuations get examined by potential buyers of companies in due diligence. If suitors come across any valuations that look too low, potentially causing a problem in any later IRS audit, they can back out of a deal. Alternatively, the buyer could require the company to cancel and reissue options which could be costly and take lots of time, company valuation experts say.

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Scott Spector, an attorney at Fenwick & West LLP, says he thinks it’s unlikely the IRS is going to start giving 409A valuations any extra scrutiny any time soon, but he does tell his clients to make sure they conduct the valuations properly. “It’s not so much what the IRS might say, it’s what an acquirer or its advisors might say when they’re buying your company years after an options grant,” he says. An IRS spokesman declined to comment.

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“There are many companies out there that are creating these liabilities that they don’t know about and won’t know about until they go through the sales process.”