After Capdesk’s recent acquisition by US equity specialists, Carta, our access to industry-leading expertise has expanded to encompass experts on both sides of the Atlantic.
So we brought our in-house experts Triam Zubeldia, UK Valuations Associate, and Jackson O’Brien, US Valuations Manager, together to cover EMI, CSOP and 409A valuations. During the webinar, they defined the valuations processes, explained how valuations affect equity grants and shared insights about why it’s an integrated cap table and valuations platform makes equity management more efficient.
Understanding HMRC valuations
Triam kicked off the conversation with a broad overview of valuations for UK share schemes. “In this particular case, we’re looking at the valuation of shares for the tax-advantaged EMI and CSOP schemes. Essentially, the process involves taking the private company value and using it to establish the share value when the company wants to grant option shares for these schemes.”
Expanding on this definition, Triam described the differences between EMI and CSOP. “The main difference relates to restrictions on the schemes. With EMI, there are thresholds on gross assets and trading activities. Gross assets must be below £30 million and some services cannot take advantage of EMI. Banking and financial services, for instance.”
In contrast, CSOP is more flexible and well-suited to fast-growing fintechs in particular. “CSOP had a per-employee option cap of £30,000,” Triam noted. “However, this increased to £60,000 in April 2023, which makes it much more attractive to companies that can’t use EMI.”
In most instances, EMI is the ideal scheme to start with. But many companies will quickly hit the scheme’s ceiling and graduate to CSOP.
409A valuations essentials
Heading across the ocean, Jackson offered a rundown of the US equivalent, 409A valuations. “A 409A valuation determines the fair market value of a company’s common equity,” he began. “Using the common stock value determined by a 409A report, companies can issue stock or options to their employees at what the IRS calls a fair price.”
Comparing the 409A to an insurance policy, Jackson explained why these valuations are important. “A 409A valuation keeps you compliant with the IRS. When you need to issue options, you have that 409A report ready and the issuance process is straightforward.”
To round out his summary, Jackson introduced a key 409A concept, safe harbor. “When a valuation is conducted by an unaffiliated or independent party, such as Carta, it establishes a safe harbor for the company. This means the IRS assumes the valuation is reasonable.” A valuation only becomes invalid if the IRS proves it is grossly unreasonable. The burden of proof is with the IRS, rather than your company.
This establishes a crucial difference between 409A and EMI or CSOP valuations. While the former is a retrospective, audit-based system, the latter two require a clearance process you must complete before granting options.
The value of regularity
Next, the discussion moved to when and why valuations are necessary. Jackson argued that compliance is the main issue, but other factors play a role, too. “Companies should always be in compliance with IRC 409A, as it’s one less hoop to jump through when you’re running and growing your business.”
In many cases, 409A compliance benefits your business when it matters most. “Raising money and finding talent is hard enough,” Jackson said. “It’s good to have the 409A in place, so you can grant options to new employees using the money you raised without the additional headache of scrambling to get a new 409A.”
409A reports are valid for one year or until a material event occurs, whichever comes first. As Triam described, these specific HMRC valuations are valid for a shorter period. “For EMI, you are looking at doing valuations every 90 days and notifying them within 92 days* of issuing grants. For CSOP, you would ask for clearance just before granting.”
Continuing the discussion, Jackson explained what constitutes a material event. “For 409A, a material event typically means an outside round of financing that occurred at an updated price. It includes both a down round or an increase in value from previous financing rounds.” It can also include major business pivots, such as switching from selling clothes to building on the blockchain, and operational effects from a recession or pandemic.
Compliance is king
Of course, the most compelling reason to conduct valuations is that the regulations require them. Without an acceptable valuation in place, companies can receive significant penalties.
Triam detailed the potential ramifications in the UK. “With HMRC valuations for EMI and CSOP, not clearing your valuation for tax-advantaged schemes can cause important issues during the exit process, as the company and employees would be exposed to significant tax liabilities.”
Tax liabilities are also the main concern with 409A valuations in the US. “You put your employees and the company at major tax liability risks if you issue stock without a 409A report in compliance with the IRS,” Jackson advised.
US 409A tax liabilities are typically expressed in three different ways:
All deferred compensation from the current and preceding years becomes taxable immediately
Accrued interest on the revised taxable amount is payable
An additional tax of 20% on all deferred compensation is applied.
A positive knock-on effect
Here at Capdesk, we get a great insight into how high-growth companies in Europe use equity to attract, retain, motivate and engage employees – and this extends to valuations too. Triam brought this idea to our attention. “As a company grows and matures, we expect the value of their shares to increase, regardless of the source of capital. The aim of an equity scheme is to share this growth in value with employees as an additional way to retain and motivate them.”
Jackson continued by discussing how EMI, CSOP and 409A valuations affect the distribution of equity. “As an employee, working for a company with an up-to-date or compliant 409A report gives you peace of mind that when you’re up for equity refreshes or additional share grants, they will happen in a timely and proper manner.”
Speaking about recent changes to some European countries’ tax legislation, Jackson explored the issue of equity as an employee motivator. “Getting and keeping the right talent is everything for venture-backed companies. Most privately-held companies simply don’t have the cash flow to offer super-competitive cash salaries. That’s where equity comes in to sweeten the deal.”
“In theory, employees who receive equity should be incentivised to work harder and make their options worth something in the future. That’s the major draw of receiving equity in early-stage companies,” he continued.
The key to fast, accurate valuations
The pair rounded out the webinar by looking at the link between up-to-date, accessible cap table data and the ability to turn valuations around quickly.
Having both the company cap table and HMRC or 409A valuation on the same platform saves administrative headaches for your team. Jackson shared why this is the case. “I worked at a company that only provided valuations and getting the right cap table data from our clients was half the battle,” he said. “Knowing we have accurate cap table information allows the team to focus on valuing the company, rather than double and triple checking manual cap table data entries.”
As well as ensuring that your cap table is accurate, Carta and Capdesk provide transparency when you work with third parties, such as lawyers, accountants or advisors. For Triam, Capdesk helps companies maximise the value they get from these third-party specialists. “Using our technology and services releases a lot of professional time, which allows these advisors to focus on sharing their experience and knowledge to provide the highest value-add services to their clients.”
*However, the UK Government recently announced a change to this rule. For EMI options granted on or after 6 April 2024, you’ll simply need to include the grant notification in your EMI annual return and file it with HMRC by 6 July.