What founders need to know about 409A valuations

Equity-based compensation continues to be a popular tool for startups and privately held companies to attract employees and reward them for the value they bring to the business. Under section 409A of the IRS tax code, companies that intend to issue shares or stock options to employees and founders must first establish a fair market value of one share of common stock in the company. 

The 409A valuation allows private companies to issue common stock or options to employees at a low price while ensuring that the strike/exercise price is at or above fair market value so recipients aren’t stuck with a tax bill. Otherwise, taxes are derived based on the spread between the fair market value and the exercise price of the options. 

The current fair market value is the value at which new employee options will be priced per share. For example, if you are hired at a startup with a current 409A price of $1, the strike price for your options will be $1 per share.

The requirement for the 409A valuation was introduced by the IRS in 2005 in response to the widespread practice of Silicon Valley startups granting stock options amid the dot-come boom. The agency wanted to be sure it took its fair share of taxes on noncash components of employee compensation. 

When do you need a 409A valuation?

Every company that intends to issue common stock to employees must undergo a 409A valuation to avoid tax penalties. The 409A evaluation is good for 12 months or until there is a material change to the business that affects its value, which is typically a finance event.

Why do you need a 409A valuation?

Doing the 409A valuation can potentially save tens of thousands of dollars in tax penalties in the event questions arise from the IRS. By getting the valuation, in the view of the IRS, the presumption is in your favor that the valuation is correct, meaning it’s up to the IRS to prove it was incorrect. 

Who can do a 409A valuation?

It is best to hire a third party who is independent of the firm. However, no single body regulates the valuation profession, unlike attorneys (the American Bar Association) or accountants (the American Certified Accountants Association). Make sure when you talk to a potential appraiser or valuation firm that they have extensive experience with 409A valuations in your company’s sector or industry. They should also have broad experience in taking valuations through the entire audit process with the IRS, as the 409A’s purpose is to support a tax position.

Alternatively, someone at the company issuing nonqualified deferred compensation instruments may conduct the 409A valuation, but the method they use must be documented and grounded in established principles. There are also cap table software platforms that bundle valuation services with their software offerings, but this is an add-on rather than their core offering. 

How is the 409A calculated?

409A valuation experts agree that the process is inherently subjective and that valuation is part art, part science. When you hire a third-party valuation expert, you are paying for them to render an opinion that is mathematically supportable but also subjective. 

There are numerous methods for arriving at the 409A valuation. In the asset approach, liabilities are subtracted from the total assets, but this is more commonly used for capital-intensive businesses. There is also the income, or cash flow outlook method, and the market approach. The latter is the most common among startups and is based on comparable valuations in the market. 

Note that the fair market valuation isn’t derived by simply dividing the valuation by the number of shares outstanding as there are different types of shares. Each class of share has to be looked at separately, and value has to be allocated to each of those different classes. 

How much time does a 409A valuation take?

The length of time it takes to complete the 409A valuation depends on its complexity and how much analysis it entails. Early stage companies tend to be more straightforward and will likely entail a 10 business-day turnaround. Companies at the Series B stage may take about 15 business days. Companies that are approaching IPO or acquisition will take longer. 

Want more? In addition to 409A valuations, Escalon provides startups and small to midsized businesses with outsourced accounting, HR, CFO, tax and insurance services. Talk to an expert today.