What is a 409A valuation?

A 409A valuation is an independent appraisal that determines the fair market value (FMV) of a private company’s common stock. The IRS requires this valuation to ensure that stock options and other forms of equity compensation are priced fairly and comply with tax regulations.

Once the FMV is established, it is used to set the strike price for employee stock options and comply with IRS rules. 

It protects companies with costly penalties by accurately pricing equity, based on the company’s current financial standing rather than inflated projections.

If the strike price is too low compared to the FMV, it can lead to significant tax liabilities for employees. On the other hand, if the strike price is set higher than the FMV, the options would become less attractive for employees.

Example:

Let’s say the company’s FMV is $10 per share.

1. Strike price below FMV:

If the strike price is $5, the IRS considers the $5 difference as ordinary income and taxes it at the time of the grant, even before the options are exercised.

2. Strike price equal to FMV:

If the strike price is $10, there are no immediate taxes.

3. Strike price above FMV:

If the strike price is set at $15, employees would need to pay $15 per share to purchase stock worth $10 per share on the open market.

Why do companies need a 409A valuation?

A 409A valuation is needed for two main reasons:

1. Employee stock options compliance

When companies issue stock options, they must establish the fair market value (FMV) of their common stock to set the exercise price. The FMV serves as the benchmark to ensure the stock options are priced correctly and in compliance with IRS regulations.

2. IRS penalty avoidance

For private companies, IRC Section 409A regulates the pricing of stock options and other equity-based compensation. It mandates that stock options be issued with a strike price equal to or greater than the fair market value (FMV) at the time of issuance.

Non-compliance with IRC Section 409A can lead to significant penalties, including immediate income tax on unvested options, a 20% penalty tax on deferred income, and interest charges.

A proper 409A valuation helps protect companies from these risks, ensuring their stock options are both compliant and attractive to employees.

What is IRC Section 409A?

IRC Section 409A is part of the U.S. tax code that governs the rules for non-qualified deferred compensation plans. This includes employee stock options and other forms of equity compensation.

It ensures that employees don’t pay taxes on compensation they haven’t yet received. This applies to unvested stock options, provided the compensation complies with the regulations.

A non-qualified deferred compensation plan (NQDC) allows employees to delay receiving part of their income, such as salary or bonuses, until a later date, usually after retirement or when they leave the company. These plans are called "non-qualified" because they don't meet the specific requirements of tax-advantaged retirement plans like 401(k)s or pensions.

For companies, IRC Section 409A is crucial because it:

• Establishes strict rules for how companies must value their equity and structure their compensation plans.
• Protects employees from premature taxation.Without compliance, the IRS can require taxes on this compensation—even if the employee hasn’t yet gained access to it.
• Acts as the legal foundation for 409A valuation.

What is a 409A safe harbor?

A 409A safe harbor is a protection under IRC Section 409A that helps ensure a company’s stock option valuations are considered compliant with IRS rules. If a company follows specific IRS-approved valuation methods, the valuation is presumed reasonable, and the IRS is less likely to challenge it. This reduces the risk of penalties for both the company and its employees.

How does safe harbor work?

To qualify for safe harbor, a company must use one of the following IRS-approved valuation methods:

1. Independent appraisal method

Hiring an experienced third-party firm to perform a professional 409A valuation. The valuation must use generally accepted methodologies, such as discounted cash flow (DCF), market comparables, or asset-based approaches.

2. Illiquid startup method

This method applies to private companies that do not have plans for an immediate IPO or public offering. The company determines its fair market value (FMV) by evaluating various factors, including its financial performance, potential risks, and recent funding rounds. 

This method takes into account the fact that the company’s stock is not easily tradable on public markets, making it harder to determine its value.

3. Binding formula method

In this approach, a predetermined formula is used to calculate the fair market value of a company's stock. This method is uncommon and is typically used in specific situations like buy-sell agreements, where there is an agreement between shareholders about how the stock’s value will be determined under certain conditions

By using one of these methods, a company’s valuation is presumed valid under the safe harbor rule, making it harder for the IRS to dispute.

What triggers a 409A valuation?

You’ll need a 409A valuation at these key events:

1. Before granting stock options‍

A 409A valuation is required to set the strike price of stock options for employees. Without an accurate valuation, the company risks mispricing options and facing IRS penalties.

2. Following a major company event

‍A new 409A valuation is required if there’s a significant event, such as a funding round, acquisition, major partnership, or hitting key revenue milestones. These events can impact the company’s fair market value. As a result, the valuation must be updated to reflect any changes.

3. Every 12 months‍

Even without a major event, it's important to update your 409A valuation annually to maintain compliance. Regular annual valuations ensure the strike price stays aligned with the company’s current financial status.

Common 409A Valuation Methodologies

When performing a 409A valuation, the valuation provider applies established methods to calculate the fair market value (FMV) of a private company’s common stock. The chosen method depends on the company’s stage, financials, and specific circumstances.

Here are the most common methodologies used:

1. Market approach

The market approach determines a company’s value by comparing it to similar businesses or transactions in the market. It's especially useful for startups or companies with limited financial history.

a. Guideline public company method: This method compares the company to publicly traded companies in the same industry, adjusting for differences in size, growth, and risk.

b. Guideline transaction method: This method looks at recent acquisitions or funding transactions of similar companies to estimate value.

2. Income approach

The income approach values a company based on its ability to generate future cash flows (DCF). It is generally used for more mature companies with established revenue streams.

3. Asset-based approach

The asset-based approach values a company by determining the net value of its assets, minus its liabilities.

In some cases, a 409A valuation provider may use a combination of these approaches to account for multiple factors, such as market conditions, company performance, and industry trends.

What do I need for a 409A valuation?

A 409A valuation is an independent appraisal and to help the appraiser perform this analysis, you’ll need to provide detailed information about your business.

Here’s a checklist of what most valuation providers require:

Company details

• CEO information: Name and background of the company’s chief executive officer.
• Legal counsel: Contact details for your company’s legal representatives.
• Amended and restated Articles of Incorporation: Foundational legal documents outlining your company’s structure and ownership.
• External audit firm (if applicable): Details of your audit firm for additional financial context.

Industry information

• Comparable public companies: A list of similar publicly traded companies that can serve as benchmarks for valuation.

Fundraising and options

• Recent fundraising: Details of your most recent funding round, including investment amount valuation (pre-money and post-money).

• Stock option plans: Information about your employee equity plans, including the number of options granted and reserved.
• Liquidity event timing: Your expected timeline for an IPO, merger, or acquisition.

Financial information

• Historical financial statements: Past financial performance, including income statements, balance sheets, and cash flows.
• Forecasted revenue and EBITDA: Projections should include revenue growth estimates for the next 12 to 24 months, along with expected EBITDA margins, cash burn rates, runway calculations, and details of any outstanding non-convertible debt.

409A penalties: What happens if you don’t comply?

Failing to comply with IRC Section 409A can lead to serious financial consequences for both employees and the company.

1. Immediate taxation on deferred compensation

If the 409A valuation is not compliant:

- All deferred compensation (e.g., unexercised stock options) becomes immediately taxable, even if the employee hasn’t received the funds or exercised the options.

- The IRS applies taxes retroactively to the year the options were granted and adds penalties and interest for the delayed payment.

2. Additional 20% federal tax

Employees are hit with an additional 20% federal penalty tax on the value of the deferred compensation. This is separate from regular income taxes.

What is the difference between 409A valuation and VC valuation (pre-money/post-money)?

Companies typically rely on two types of valuations:

The pre-money or post-money valuation, which reflects the company’s worth based on investor negotiations during a financing round. This valuation is determined by what investors are willing to pay for preferred shares, factoring in market conditions and company growth prospects.

The 409A valuation, an independent assessment required for setting stock option prices for employees. This valuation determines the fair market value (FMV) of the company’s common stock, ensuring compliance with IRS regulations.

Though they serve different purposes, the 409A valuation and pre/post-money valuations influence each other:

- Pre/post-money valuations are driven by market demand and investor negotiations. They are typically based on the price of preferred shares and may not consider the company’s 409A valuation. In contrast, 409A valuations are performed by independent appraisers, using factors like the company’s post-money valuation to assess the FMV of common stock.

- A 409A valuation is based solely on the price of common stock, while pre/post-money valuations usually reflect the value of preferred stock, which offers more rights (like liquidation preferences) than common stock.

- 409A valuations must meet IRS requirements to avoid penalties, ensuring they hold up under regulatory scrutiny. Pre/post-money valuations, however, are not subject to the same level of compliance oversight.