409A valuations — why get one? What to expect.

Is a 409a valuation required for your startup? If your company is less than a year old, if the value of your business has not increased significantly over the last year or if you are not planning to issue new employees stock options, you can skip this post and go back to growing your business. If you have recently raised a round of capital and/or are ramping up hiring — read on.

Most founders become aware of the need for a 409A valuation when they are told by an investor, attorney or advisor that it’s required by law. If you ask why, they will likely tell you to keep on the right side of the IRS and simply get it done.

Some industry experts believe this law is broken. That Section 409A does little to reduce tax avoidance — companies can easily work around its requirements, and it makes using deferred compensation complicated for everybody.

Our objective for this post is not to solve the debate on Section 409A but to help founders get a better grasp on when to engage in the process, how to do it right and what to expect when you get going.

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What is the intended purpose of Section 409A?

Thanks to the famous corporate shenanigans at Enron, Section 409A of the tax code was introduced in 2005 to more tightly regulate deferred compensation: any arrangement where a portion of an employee’s income is set aside to be paid at a later date.

Section 409A introduced a series of rules companies must follow when deferring compensation for employees and contractors. These rules were designed to objectively value the deferred compensation and make it easier for the IRS to tax it properly.

If the company complies with the rules, management and employees can go about their business normally. If they don’t, they run the risk of a visit from the IRS and a series of of steep penalties.

Startups are power users of deferred compensation.

For startups deferred compensation plays a critical role in employee pay through the frequent use of stock options. At their core, stock options represent an agreement between employees and management: “Our company is young and we don’t have a lot of money to pay you right now, but if you help us build a great business we will reward you with a share in its future value.” Startups are power users of deferred compensation.

The deferred compensation nature of options bring them in direct contact with 409A requirements, specifically in the option strike price. A stock option strike price is the price an employee pays for the options she is given by the company. Since the gain (profit) the employee makes when executing her options is calculated by the difference between the share price and the market price at the time of the transaction, the lower the strike price the higher the gain. The IRS is particularly concerned with who/how the option strike price is calculated and requires an independent valuation firm to value the company to make sure the strike price is not arbitrarily set.

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What could possibly go wrong?

New startup employees don’t want to worry about things like being paid on time or stock value and typically place their full trust in founders to take care of these critical issues. Since stock compensation programs are so important in keeping a team engaged and motivated, founders need to be on the lookout for factors that can erode trust and damage incentives.

Skipping a (or doing a poor) 409A valuation could have devastating effects on the way employees perceive both the value of their stock option grant and the competency of the management team.

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Employees might get an unpleasant tax surprise

Employees tend to associate stock options with future value and potential wealth, not with a painful tax event today. Granting stock options with a strike price based on a flawed 409A valuation can result in steep tax penalties and an unpleasant experience for the employee.

The IRS specifies — “ If the arrangement does not meet the requirements of Section 409A, the compensation is subject to certain additional taxes, including a 20% additional income tax”

Technically this means that if the company compensates employees with stock options, but the strike price was not properly set via a defensible 409A valuation, the employee could be liable as follows:

• The value of the stock option grant can be taxed as income for the current tax period.
• There is an additional 20% penalty also due during the current tax period.

A poorly done 409A valuation can turn the motivating promise of future wealth into a present day tax nightmare.

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About that strike price — changing the terms of a stock option offer.

Since strike price plays such a big role on the value of deferred compensation the exact number plays a big role in new hire pay. When a new employee receives an official stock option grant she will use her strike price as the baseline for her future financial gain.

Imagine a scenario where a few months after a new employee joins the company you have to go back and tell her the strike price approved by the Board of Directors was too low and now has to be increased.

Completing a properly done 409A valuation at the right time will help you avoid the loss in engagement and trust that can come from an undesired renegotiation.

Other reasons for staying on top of 409A valuations.

When raising a new round of funding or engaging a potential acquirer one of the most important steps to get to a close is to successfully complete the due diligence process. In due diligence an investor or buyer is looking for evidence that all legal and financial aspects of the company are in good order and there will be no obvious negative surprises in the future.

Lacking a proper 409A valuation paper-trail could become a contentious point in the due diligence process and potentially increase the risk of a close. Make sure you enter due diligence with your documents and books in order and a high quality 409A valuation done by a reputable source.

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What can I expect from the 409A valuation process?

Regardless of who you partner with to complete your 409A valuation you can expect the process to cover the following 3 steps:

1. Timing

On average a 409A valuation process can take a few weeks to a couple of months. To avoid a last minute rush you should plan to start the process in advance of key events like a ramp in employee hiring. The basic idea is to be ready to issue new options with a freshly set strike price by the next board meeting after new employees come on board.

Startups with healthy growth trajectories tend revisit the 409A valuation process on a yearly basis. Check with your consultant at least once a year to verify if a new process is needed.

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2. Document delivery

The actual valuation process starts with sharing a set of documents with the consultant that are used to calculate the value of the business. The required documents are grouped in 4 categories:

1. Basic documentation and housekeeping

• Basic data on company — when founded, where, etc..
• Incorporation Documents
• Information about the business, market and products.
• Up to date Cap Table — Who owns shares.

2. Funding and current value estimate

• Details and documents on financing rounds
• Information on current valuation
• Historical 409A valuations

3. Financial Performance

• Current balance sheet
• Income statement

4. Company’s place in the market and future trajectory

• Company timeline with a projected view of future events like rounds of funding, product launches, etc…
• List of competitors and/or comparable companies

Depending on their level of organization most companies should be able to turn around the requested documents in a matter of days. If on the other hand you need to create new financials or update your cap table, completing the request can take weeks. Keep in mind the timing of this part of the process in entirely in your hands and the more organized you are the faster it will go.

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3. Valuation Process

Once the the consultant receives all the requested documents they will begin the process of estimating the actual value of the company. The methodology for arriving at a valuation can change from firm to firm but at their core they all look for objective ways of measuring value. A great consultant will also draw on years of experience valuing hundreds of companies and combine it with quantitative methods to get to the right valuation. Depending on the methodology used by the consultant and the experience of their team, this stage of the process can take from 2 to 4 weeks.

Before the consultant submits their final report they will schedule a phone call to discuss their findings and give you an idea of the value they will assign to your business. This critical conversation gives you an opportunity to ask questions on methodology, clarify assumptions and make sure your voice is heard in the process.

Once their process is complete you will receive a letter (PDF) with their official report and estimated value on how much the business is worth.

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Important note

In recent years a number of firms have started offering inexpensive 409A valuations done through purely algorithmic methods or teams located outside of the US. A valuation created by a computer or an inexperienced consultant can fail to meet the safe harbor requirements of the tax code and result in an invalid report. Make sure your valuation is performed by a human expert that can answer any questions you might have on how they arrived at the reported value.

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What to do with your 409A valuation report

Once you have a complete valuation report you need to do a few things before the process is complete.

First, study it carefully to check if the consultant took into account any feedback you gave them during the review conversation. Once you agree with the valuation, you must then get it ratified by the Board of Directors. Most companies complete this step by adding the discussion to the next board meeting’s agenda. The board discussion usually includes approval of a stock option strike price based on the new valuation. With Board approval and a freshly minted strike price the valuation process is complete and you can proceed to issue stock options.