Most founders aspire to scale their startups and become public companies. However, having a great product and a compelling mission statement will only take the company so far. That’s why it’s critical that you attract and retain the best talent to work for your business. This is where incentivizing them with a competitive package of equity-based compensation can do the trick, which you can do by offering stock options.
But here’s the challenge: how can a new, private company offer common stock options if it doesn’t have a share price for its common stock yet?
That’s where a 409A valuation report enters the picture.
What is a 409A valuation report?
A 409A valuation report assesses the fair market value (FMV) of a private company’s common stock and is done by an independent third-party appraiser. This is important because it determines the 409A strike price: a set price at which a startup’s stocks can be bought or sold. The valuation also establishes the price at which founders can provide stock options to employees tax-free.
It’s also a legal requirement under Section 409A of the IRS’s Internal Revenue Code (IRC), which requires startups to comply or face hefty penalties. Though a 409A valuation report may sound straightforward on paper, the reality is that it’s more complicated than you might think.
Fact-checking 5 myths of 409A valuation report
Given the complexities surrounding 409A, it shouldn’t be surprising that there are several misconceptions surrounding the valuation report. In this article, we’ll bust five of the most common myths surrounding the valuation report, giving you much-needed clarity on this complex subject.
Myth 1: Low valuations are always bad
The idea of getting low 409A valuations can bring chills down your spine, especially if your startup is in its early stages. But this may not necessarily be a bad thing. In fact, many industry experts view this situation as a boon because it allows companies to grant employees stock options at a lower price.
Additionally, startups can use the new, lower 409A valuation as a recruiting tool, enticing potential employees with cheap options and the promise to cash out at a much higher rate once your startup moves into the growth stage.
Myth 2: The lower the strike price, the better
Getting a low 409A strike price indicates that your startup’s shares can either be bought or sold at a lower rate. While this sounds beneficial to your employees, having a strike price that’s too low may not accurately represent the true value of your company’s stocks. It could also lead to further issues related to taxes and audits.
For a start, having a lower strike price can put your business at risk with the IRS. In case the actual strike price turns out to be higher than what you had set, your startup loses its safe harbor status, sending your employees to bankruptcy. This can happen when a strike price is set so low that it doesn’t align with what the IRS sees as FMV. Remember, employees’ options are taxable, and this can result in them facing colossal income tax bills they weren’t expecting. As an employer, you will also be held accountable for withholding obligations.
The IRS may also challenge your past valuations due to the latest low valuations, even if a certified appraiser has done it. To make matters worse, you may also find it tough to convince your investors to raise any funds for the business and could lose your credibility as a brand. Moreover, it sends a red flag to potential talent to not join your company.
Myth 3: Nobody checks 409A valuations
The common misunderstanding with 409A valuations is that they will not be checked by anyone as their sole purpose is to establish the value of a private company’s common stocks meant for employees. But the reality is that valuations are constantly checked by regulators, investors, and even stakeholders.
For example, failure to comply with the 409A valuation requirements puts your startup at risk of losing its safe harbor status. This can then trigger IRS audit sessions, resulting in impending legal troubles, tax issues, and even interference with the company’s functions.
Myth 4: 409As only affect employees
While the main purpose of 409A valuation is to set the strike price to enable offering equity to employees, it also affects potential and existing investors and other stakeholders. Generally, investors and management want to check the 409A valuations to determine your startup’s financial standing. Having these insights can help them make sound decisions regarding investment and funding. For instance, an appraiser will most likely increase the 409A valuation if your startup comes off a large fundraiser. This will indirectly affect investors by increasing the strike price of an employee’s stock options.
Myth 5: 409A valuations are overly expensive and time-consuming
The cost to get a 409A valuation report varies, depending on the size and complexity of your startup. Generally, it could cost anywhere from $1,000 to over $5,000 (or even $10,000 for large corporations). Given that getting a 409A valuation is a legal requirement for private companies, forking out such a large sum of funds can be burdening for your business, especially if you’re in the early stages.
As such, if you’re looking to minimize the total costs of a 409A valuation, then deferring to a professional valuation service provider can be your solution. However, be mindful to pick a provider with the knowledge, expertise, and training to get you a 409A report that complies with IRS’ requirements. Doing so could save you potential trouble and unwanted penalties from the IRS.
How to best obtain a 409A valuation?
Being aware of all the details surrounding a 409A valuation report is crucial for a startup. But we must admit that the process can be extremely complex, resulting in founders feeling overwhelmed and confused. Getting a 409A valuation from a credible provider is the best way to avoid that slump altogether.
You’ve debunked the myths surrounding the 409A valuation report—what’s next? Discover 409A penalties and how to effectively avoid them!
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