What is a 409A valuation?

What is a 409A valuation?

A 409A valuation is an assessment of the fair market value of a private company’s common stock by an independent third-party appraiser. The assessment findings are communicated as a written valuation report to the company’s board of directors who determines and sets the stock price for shareholders or traders.

What is Section 409A?

The name of this valuation comes from Section 409A of the U.S. Internal Revenue Code (the “tax code”). Section 409A was enacted in response to alleged abuses of deferred compensation arrangements revealed in several high-profile corporate scandals.

Among other things, Section 409A requires that options granted as compensation to service providers (employees or non-employees) have an exercise price, also known as the strike price, equal to or greater than the fair market value of the shares underlying the options on the date they are granted.

If an audit reveals that options were granted with an exercise price below fair market value, then the service provider who received them may be subject to tax penalties.

What is 409A safe harbor?

By adhering to specific guidelines, your 409A can be considered "safe harbor" by the IRS (Internal Revenue Service), providing reassurance as the IRS presumes it valid unless proven to be grossly unreasonable.

IRC 409A offers three methods, known as presumptions, where you can attain a safe harbor valuation:

• Binding Formula Presumption
• Illiquid Startup Presumption
• Independent Appraisal Presumption

The independent appraisal presumption, in which a qualified independent appraiser or third-party valuation firm performs the 409a valuation, is the preferred way to achieve safe harbor status due to their expertise and timeliness.

What is a 409A valuation used for?

A 409A valuation is often used for granting stock options by startups or private companies to attract talent. To grant employees stock options tax-free,  409A valuations are required since the common stock value of privately-held companies isn’t readily available.

What is the purpose of a 409A valuation?

The purposes of a 409A valuation are to:

• Determine the fair market value (FMV) of a private company's common stock
• Set the strike price for options issued to founders, employees, and anyone who receives the stock
• Ensure companies adhere to guidelines in the Internal Revenue Code
• Protect employees from taxes and IRS fines

Do I need a 409A valuation?

If your startup or private company plans to grant stock options to employees or advisors, then you will need a 409A valuation before those stock options are issued. Another circumstance would be a financing round (or any major financial or operational changes). Generally, you should obtain a 409A valuation from a qualified valuation firm.

Are 409A valuations public?

No, 409A valuations are not public, nor are they filed with the IRS (however, take note that the IRS may request to review your 409A valuation during an audit). Valuations include confidential financial and business information about your company, and the report is typically only shared with the board of directors, management team, and legal and accounting advisors.

What are the 409A valuation methods?

409A valuations are typically performed by independent appraisers. However, other methods are possible if the budget is tight—you can do it yourself, or use an online tool.

How long does a 409A valuation take?

The length of time for a 409A valuation can vary depending on several factors:

• The startup’s nuances
• The amount of information available
• The valuation method

Typically, a 409A valuation performed by an independent appraiser or valuation firm can take anywhere from a few weeks to several months.

How long is a 409A valuation good for?

A 409A valuation is valid for a maximum of 12 months from the date of the report—or until a material event happens (e.g. a merger, change in legal status, priced equity financing) because it will affect your startup’s stock price. Therefore, the frequency of conducting 409A valuations should be at least once a year, or when a material event has occurred.

How do you ensure the valuation is valid?

Obtaining a 409A valuation from an independent appraiser is a “safe harbor” method to determine fair market value detailed in the tax code. If you don’t use a safe harbor method to determine your startup’s stock value, then the valuation it arrives at has no presumption of validity. Plus, during an audit, you must prove that your valuation is reasonable. That may entail producing financial documentation from the time you provided option grants, adding to the burden.

If you use a valuation safe harbor instead, then the valuation that you obtained is presumptively valid; the burden of proof shifts to the Internal Revenue Service to determine that the valuation is “grossly unreasonable,” which is a high threshold. 409A valuation reports are valid for one year following the valuation date, unless a material event affects the valuation of the company’s stock (e.g., venture financing).

Prices for independent 409A valuations can cost several thousand dollars per year, but doing it the right way helps avoid the consequences of miss-pricing equity awards.

In addition, not choosing a 409A safe harbor to determine fair market value when making equity awards may cause increased deal friction when raising financing or at the time of an exit (i.e. an acquisition or an IPO) because compliance with Section 409A can be a point of legal and tax scrutiny.

409A valuation vs investor valuation

A 409A valuation is done for a private company to establish the fair market value (FMV) of its common stock, determine the strike price of the options, and protect employees from taxes and IRS fines.

An investor valuation (also known as VC, venture capital, or pre-money valuation) is performed by VCs to determine the value of the company as well as its potential for growth, profitability, and ROI.

409A valuation vs IPO price

A 409A valuation is done for a private company to establish the fair market value (FMV) of its common stock, determine the strike price of the options, and protect employees from taxes and IRS fines.

An IPO price, on the other hand, is the price at which a company’s stock is sold to the public for the first time before it is traded on a stock exchange. It is gauged and set by underwriters and investment banks based on various factors such as the company’s financials and investor demand.

What is a 409A plan?

A deferred compensation plan can be qualified or non-qualified.

409A plans, or nonqualified deferred compensation (NQDC) plans, are not subjected to the same limitations applicable to QDC plans. They allow service providers (employees) to earn wages, bonuses, or other compensation in a year but receive the earnings — and defer the income tax on them — in a later year.

NQDC plans are also regulated by section 409A of the IRC and if certain rules are breached, a 20% penalty tax is typically imposed on the employee, in addition to immediate taxation of deferred amounts.

‍Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.