What is a 409A valuation, and when do I need one for my startup?

When a startup offers stock options, it needs to know the price of its stock to meet tax laws and avoid penalties for its employees. Even if it weren’t required by law, knowing the stock price when issuing options means it’ll be priced fairly, which builds trust with your employees and investors.

That’s where a 409A valuation comes in.

In this article, we’ll walk you through what a 409A valuation is, why your startup needs one and when it’s required.

What is a 409A valuation?

A 409A valuation is an independent assessment of a private company’s stock value. It’s named after Section 409A of the Internal Revenue Code.

This valuation sets the fair market value (FMV) of a company’s stock and the price at which employees can buy the stock – this is called the ‘exercise price’. The valuation is necessary in order to comply with the Internal Revenue Service (IRS) rules – without it, anyone receiving stock options could face serious tax issues.

Why do startups need a 409A valuation?

As a startup, offering stock options is an important tool to attract talent. It not only helps you bring in great people, but it also means their goals are aligned with yours – they’ll work to grow the company because they’ll eventually own a piece of it.

But when you’re offering stock options, you’ll need to know the price of the stock you’re offering. This is because the IRS requires companies to price these options at or above the FMV of the stock at the time of issuance. If the FMV is set too low, employees could owe taxes and penalties on the difference.

So, a 409A valuation is needed to establish the FMV.

When do you need a 409A valuation?

According to tax law, you need to do a 409A valuation whenever the company goes through a ‘material event’. Here are the key times you’ll need one:

• Before issuing stock options: If you’re offering stock options to employees, you’ll need a 409A valuation to determine the exercise price.
• After a funding round: Fundraising can change your company’s value, so it’s important to update your 409A after each fundraising event.
• Every 12 months: A 409A is valid for one year or until a material event. So, if it’s been 12 months, you should get a new 409A valuation.
• Before an IPO or acquisition: If your company is preparing for an exit event, getting an updated 409A valuation is crucial to make sure you’re compliant in pricing your stock.

There are other things that could constitute a ‘material event’ – like a major product launch or a big change in financial performance. These sorts of things can trigger the need for a new 409A valuation.

How does the 409A valuation process work?

A 409A valuation is done by an independent third party to ensure it’s objective. The process involves three key steps:

1. Calculating the company’s enterprise value: The appraiser estimates your company’s total value using different valuation methods (discussed below).
   
2. Allocating value across stock classes: They determine the FMV for each class of stock, including common stock (usually for founders and employees) and preferred stock (typically for investors).
   
3. Applying a discount for illiquidity: Since common stock in a private company can’t be easily sold (meaning it’s ‘illiquid’), a discount is applied to account for that.

Common methods to calculate the company’s value in a 409A include:

• Asset-based approach: This approach values the company based on its net assets and is often used for very early-stage startups that haven’t yet raised significant money or generated revenue.
  
• Market approach: This approach is common for early-stage companies that have recently raised a funding round. The appraiser uses the price paid by investors for preferred stock and applies a model to determine the FMV of common stock.
  
• Income approach: The income approach estimates the value of a company based on its future cash flows, which are then discounted to present value. This method is usually used for more mature companies with reliable financial forecasts.

What happens if you don’t get a 409A valuation?

If you don’t get a 409A valuation, your employees could face big tax penalties. That’s because the IRS may decide that the stock options were given at a lower price than the FMV – this means employees could be taxed on the difference between what they paid for the stock and what the IRS thinks it was worth. On top of that, they might have to pay an extra 20% penalty too.

For example, say you give an employee 5,000 stock options with an exercise price of $2 each. If the IRS later decides the FMV was actually $6 at the time, the employee would immediately owe taxes on the $4 difference per option. That’s $20,000 in taxable income ($4 x 5,000 stock options), plus a 20% penalty, which would add another $4,000.

A valid 409A valuation gives your company “safe harbor” status. This creates a presumption that your stock price is reasonable, meaning that, if the IRS ever audits the company, the burden is on them to prove otherwise.

So, now you see why getting a valuation is so important – it reduces the risk of unexpected and significant costs for employees with options.

How to choose the right 409A valuation specialist?

Picking the right 409A valuation provider is key to getting an accurate and reliable result. Here’s what to look for:

• Experience and expertise: Make sure the provider has plenty of experience doing 409A valuations, especially in your industry. Check how many they’ve done and their knowledge in your sector.
• Qualifications and credentials: Look for specialists with relevant certifications like Certified Valuation Analyst (CVA) or Accredited Senior Appraiser (ASA). They should understand the valuation methods and principles well.
• Reputation and references: Check reviews and testimonials, and talk to other companies who’ve worked with them. Ask about the quality of their report and how responsive and professional they were.
• Compliance and reporting: Ensure the provider knows the IRS guidelines for 409A valuations and follows all the necessary compliance and reporting standards.
• Customisation and flexibility: Make sure the provider tailors the valuation to your specific business needs, considering factors like funding rounds, market conditions, or unique aspects of your industry.
• Timeliness and efficiency: Choose a provider who can deliver the valuation on time. They should have efficient processes for gathering data and completing the analysis.
• Cost and value: Compare prices, but focus on what you’re getting for the cost. You want good value – accuracy, quality, and professionalism matter more than just the lowest price.
• Communication and collaboration: Look for someone who communicates clearly and is open to collaborating with your team. They should explain complex concepts simply and be responsive throughout the process.