The 409A valuation allows private organizations to issue common stock or options to their workers at a low price while ensuring that the strike/exercise price is at or above fair market value so recipients are not stuck with a high tax bill. Otherwise, taxes are derived based on the spread between the fair market value and the exercise price of the options.
The IRS introduced the requirement for the 409A valuation in 2005 in response to the widespread practice of Silicon Valley startups granting stock options amid the dot-com era. The agency wanted to be sure it took its fair share of taxes on noncash components of employee compensation.
Every business that intends to issue common stock to its employees must undergo a 409A valuation to avoid tax penalties. The value of the 409A is determined by an external agency. The valuation is good for one year or until there is a material change to the business that affects its value, which is usually a finance event such as a fresh round of funding.
Why is a 409A valuation important?
Stock options are accorded a set price, which is known as the strike price. The strike price is related to the 409A at the time the option is granted, and this does not change. What changes is the firm’s valuation, which is reflected in the 409A valuation. That is what has an effect on the fair market value.
When workers go to buy, or exercise, their options, they are required to pay taxes on the difference between their strike price and the current fair market value. This is because the IRS considers the increased valuation of the stock as income, which could be subject to the alternative minimum tax or income tax.
Most employees prefer to wait and watch when it comes to their equity. Once they think their employer organization has reached a safe level, like, say, becoming a unicorn, they feel it is less risky to buy their stock options.
For new employees, a lower 409A valuation means a lower base cost of their equity, which makes the salary package a lot more attractive, since a dip in valuation does not necessarily mean the firm will not have a healthy exit. For current workers, it implies that they can pay less to exercise their options and be prepared for a possible exit more effectively.
Additionally, doing the 409A valuation can potentially save a business 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 the business’ favor that the valuation is correct, meaning it is up to the IRS to prove it was incorrect.
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Should a company reevaluate its 409A for the current economic climate?
A decline in a company’s 409A valuation does not mean that the business is failing, nor does it mean that its subsequent effort to raise funds is condemned. In fact, an updated internal valuation could indicate that a company is making moves to recruit and sweeten the deal for prospective employees because 409A could help with recruiting and retention.
The cost of employee stock options is important, especially in an environment that is riddled with employment volatility, inflation and a down market. “A quarter of American startup employees can’t afford to exercise their stock options, both because of financial risk of exercising and paying taxes, or because they can’t front the cash,” according to an EquityBee survey.
There are several factors that have a major impact on an organization’s common stock valuation, including the type and amount of capital raised, latest secondary market transactions, projected cash flow and future business plans and so on. And since the employees’ equity does not update with the rest of the market, reevaluating the 409A now makes the most sense.
Carta, a San Francisco, California-based technology company that specializes in capitalization table management and valuation software, has some advice. According to Carta, if one or more of the following is applicable, businesses should consider updating their 409A:
• If the business has raised money in late 2021 or early 2022, essentially when conditions were favorable but have since passed. If a firm raised capital during this period, it may be eligible for an equity adjustment that could potentially lower its valuation.
• If the firm has made significant changes to its forecasts due to the extended downturn.
• If the company is considering raising funds in the foreseeable future.
• If the business is slowing down its cash burn rate given the funding market. If it has less available cash, it may need to be reassessed for the risk associated with limited funding.
• If the organization is planning an exit in the next one year. “The road from private to public is taking a lot longer as the IPO market has slowed due to market volatility,” says Chad Wilbur, vice president of valuations at Carta. “Companies likely need to revisit any assumptions made about the expected time to exit — especially if they operate in an industry that’s seen a significant decline in the public stock market, like technology.”
Basically, most businesses — unless they are completely heads-down, bootstrapped or have raised money in 2020 and are not looking to raise more again anytime soon — should be rethinking their 409A valuations.
Conclusion
Although it seems counterintuitive, a reevaluated, lowered valuation could offer several benefits to the existing staff members and in particular a firm’s efforts to recruit new employees. On the other hand, a high valuation increases the cost to buy, or exercise, those stock options.
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