One important way to attract top talent is with an enticing compensation package. For many companies, these include stock options. A 409A valuation is an independent appraisal of a company’s common stock, and is a tool to determine fair market value when issuing equity to employees.
This guide will cover what a 409A valuation is, why companies need a 409A valuation, how they affect stock options, and more.
Key Points
• A 409A valuation is an independent appraisal that determines the fair market value of a private company’s common stock.
• It is required for companies issuing stock options to comply with IRS Section 409A regulations.
• The valuation helps ensure stock options are priced fairly, avoiding tax penalties for employees and the company.
• 409A valuation methods include the income approach, the asset approach, and the market approach.
• 409A valuations are typically updated annually or after significant company events, like funding rounds or acquisitions.
How a 409A Valuation Works
When a company is public, shares of its stock trade on the open market. Value is determined by what buyers are willing to pay for each share. However, when a company is private, setting stock value — and ensuring it aligns with Internal Revenue Service (IRS) rules — is a bit harder. This is where a 409A valuation comes in, and they can be important to understand when starting a small business.
A 409A valuation is conducted by a third-party to determine the fair market value of common stock. The main purpose is to set an exercise, or strike price, the price at which employees with stock options may buy company stock at a future date.
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Why Companies Need a 409A Valuation
The IRS requires a 409A valuation for legal and tax compliance. The rules emerged after events in the early 2000s, including the Enron scandal in which executives were manipulating options to enrich themselves. The 409A regulation prevents companies from issuing artificially low stock options by requiring that strike prices are set at or above fair market value.
When companies set strike prices, the IRS will compare this price against the 409A valuation, and if there are any differences, it may levy severe restrictions or penalties.
How a 409A Valuation Affects Employee Stock Options
Employee stock options are typically offered as part of a compensation package. Startups often use them to attract top talent when they may not have enough capital to offer competitive salaries in cash alone.
Stock options give employees the chance to buy company stock at a later date at a pre-set fixed price. This is known as the strike price. Companies must set the strike at or above the fair market value set by the 409A valuation. Ideally, the value of the stock will continue to increase from this price, and by the time the employee purchases shares, they can then sell them at a profit.
409A Valuation Methods
There are several ways used to determine valuation, including:
• Income approach: This method is suitable for startups that are generating revenue and have a relatively stable cash flow. It accounts for company assets and liabilities to determine fair market value.
• Asset approach: For startup companies that haven’t yet begun to generate income, the asset approach looks at net assets alone to determine value.
• Market approach: Another method used for startups that have yet to generate profit, the market approach compares the company to other similar companies to determine value.
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How Often 409A Valuations Are Required
Startups need to carry out 409A valuations at least once a year, and sometimes more often. Valuations are required if there is an event that causes material change to the value of a company. Such events might include:
• Hitting or missing a milestone, such as the launch of a new product.
• Achieving a new round of funding from investors that might affect the stock price.
• Before an initial public offering or a merger and acquisition.
• During a recapitalization event where a company might alter the mix of equity and debt financing.
409A Valuation Compliance and IRS Rules
When setting fair market value for common stock, you must get a 409A valuation in order to comply with IRS rules. This includes getting an independent appraisal from a qualified third party who does not have a conflict of interest with your company.
Failure to obtain a 409A valuation can lead to IRS penalties. For instance, options might be deemed underpriced and could be subject to an immediate tax of 20% in addition to other federal and state monetary penalties. Employees hit with unexpected tax liabilities could file lawsuits against the company.
A certified 409A valuation from an independent third party provides what is known as a “safe harbor.” This means that in the case of an IRS audit, your company will have some legal protection that a valuation was made in good faith.
409A Valuation for Startups
As mentioned previously, startup companies often offer stock options as a way to stay competitive with more highly capitalized companies when attracting talent. As a result, 409A valuations can be an important — and ongoing — part of business operations for new private companies.
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Common Mistakes to Avoid with 409A Valuations
In order to ensure IRS compliance, watch out for these common pitfalls when carrying out 409A valuations:
• Using inaccurate data. Be sure that figures used to calculate value are up-to-date and as realistic as possible.
• Missing recent business developments. Material events must be accounted for, as well as any new risks or liabilities.
• Choosing an incorrect method. Choosing a valuation method that’s inappropriate for your business can lead to distorted valuations.
How Much Does a 409A Valuation Cost?
The cost of 409A valuations varies widely depending largely on what stage a company is in. Early-stage startups might expect to pay up to $5,000 for a valuation. As companies grow, their finances tend to get more complex, and the price of valuation goes up. More mature private companies might expect to pay significantly more.
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How to Get a 409A Valuation
To secure a 409A valuation, you will need to engage a third-party provider. Look for companies who have certified appraisers, a strong reputation, and a track record of proven results. You may also wish to engage a company with a support team that can grow with the company. Finally, it may be worth considering whether the valuation company offers audit support.
To pay for the 409A valuation, you can use money from your small business checking account, take out a small business loan, or put the expense on a small business credit card.
The Takeaway
A 409A valuation is a critical step as startups seek to set a fair market value for their shares. It ensures that equity compensation is priced fairly and protects the company from compliance risks from the IRS. Choosing the right partner to perform the valuation can help ensure accuracy, defensibility, and confidence in the outcome.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the purpose of a 409A valuation?
A 409A valuation helps set fair market value for a company’s common stock. It is required by the IRS, and is especially important when offering employee stock options.
Who performs a 409A valuation?
Experienced third-party appraisers offer 409A valuation services.
How long is a 409A valuation valid?
Companies must go through the 409A valuation process every 12 months. In some cases, they may need to perform a valuation sooner if there has been a material event that has an impact on the value of the company, such as a new round of funding or if the business is acquired by another company.
How does a 409A valuation affect stock option pricing?
The 409A valuation sets the fair market value for common stock. The strike price, the price at which stock options may be bought, must be equal or greater to this amount.
What happens if a company doesn’t get a 409A valuation?
The IRS requires 409A valuations. Companies that don’t comply can face stiff penalties — and their employees who purchase stock can, as well. For instance, if the IRS considers stock options to be priced below fair market value, it will trigger immediate income tax for employees when the options vest.
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