As a startup founder, you may want to offer stock options to employees to help attract and retain talent. Before offering stock options to employees, you will need to obtain a 409A Valuation of the company’s stock. The 409A Valuation is an estimate of the company’s stock price that will be used when determining the price of stock options.
What Is a 409A Valuation?
A 409A Valuation is the valuation of a private company’s common stock that is done independently to determine the fair market value of that company. In simple terms, it provides the value of one share of a startup when establishing strike prices for stock options.
The key reason a 409A Valuation is necessary for startups is that it creates the strike price for an employee’s stock options; thus, when the employee eventually buys shares of stock from the company. By law, the company must set the strike price for stock options at or above the fair market value of that stock at that time; so if the option is being sold with a strike price below the true value of that stock, then the employee is being sold stock for less than its true value and the company is violating tax laws which may subject it to significant penalties from the IRS. A properly prepared 409A Valuation establishes a reasonable market-based value for the company’s common stock.
Why Do Startups Need a 409A Valuation?
Legal Compliance (to Avoid Penalties) – If your startup is offering stock options to employees, you are required by U.S. tax law to complete a 409A Valuation. If you do not complete the valuation or use a value that is so low that it is not a reasonable approximation of the company’s common stock, the company could be penalized by the IRS for undervaluing its common stock. Worse still, employees may owe federal income tax on any “discount” they received immediately, plus be penalized 20% – which is not good news for anyone! In summary, if you fail to get an accurate 409A valuation, stock options which should be a wonderful reward for employees may instead turn into a financial disaster.
When you obtain an accurate 409A valuation, you are also protecting your employees from the possibility of having to pay additional taxes in the future due to a change to their stock option pricing. Stock option programs should be a benefit to employees rather than an added burden. By having the proper price established at the time of the grant, employees will not receive a “surprise” tax bill when exercising their options.
When Should You Update a 409A Valuation?
A 409A valuation is valid for a maximum of one year or until the occurrence of a “major” company event (e.g., funding). You should plan to perform a new 409A valuation after each time you obtain additional funding, at least once every 12 months and after any “major” events.
As soon as you close on an investment, obtain a brand new 409A valuation since the presence of new investor capital and the investment price for your shares directly impacts your overall company valuation. The fair market value of your common stock must reflect all these changes.
At least once per year, you should refresh your 409A valuation to ensure it is a valid representation of your company’s fair market value. Many different things can happen for one year and by having an up-to-date valuation, you will remain in compliance with the IRS safe harbor provision.
Also, whenever your company experiences a significant milestone (e.g., acquisitions, mergers, etc.), you should obtain a new 409A valuation. If you want to have a firm understanding of the valuation process after obtaining first revenue or a major partnership, you will need to obtain a 409A valuation.
How to Obtain a 409A Valuation
To obtain your 409A valuation, you should consult with an independent professional appraiser or appraisal firm that specializes in providing valuations for 409A purposes. An independent appraisal will help you establish a presumption of “Safe Harbor” and therefore be viewed as credible by the IRS, making it less likely that the IRS would contest your valuation. If you conduct your own valuation using the DIY methodology, this approach will be viewed as less credible than using a third-party professional appraiser, and as such, the IRS could easily contest that value.
What Does a Professional Appraiser Evaluate?
The independent professional appraiser will evaluate several factors when determining the value of your shares. The appraiser will assess the information found on your cap table (the record of who owns what of the company, including any preferred stock rights), the company’s ongoing financial performance and financial forecast, the prices that others pay in recent transactions, and the valuations of the independent professionals who evaluate similar startups to determine the value of comparable companies (comparable companies may consist of publicly traded companies or private companies). Additionally, the appraiser might consider other significant liabilities or obligations that could affect the value of the company. The independent appraiser will use the above referenced input to determine the fair market value of a common share.
Timeline and Report: What to Expect
The 409A valuation process will typically be completed within a few weeks of your providing the required documents (e.g., company cap table), and the independent valuation professional completing the review/analysis of the information and documents provided. Within approximately 2 to 4 weeks of your providing the required documents to the independent professional appraiser, you will receive a written report indicating what the professional believes the fair market value of your company’s common stock is per share. You can use this report to establish a basis for pricing your employees’ stock options.
Why ERB Is an Ideal Partner for Your 409A Valuation
The 409A valuation can be a simple process if you have an experienced partner like ERB by your side. ERB’s professionals understand the startup financing process and can assist you with every phase of the 409A valuation:
Tax Knowledge and Experience: ERB has provided advice to startups for over 30 years. Our team in New York and California is comprised of Certifying Public Accountants (CPAs) who are familiar with IRS regulations. We have assisted many startups to execute their taxable 409A valuations and we have a comprehensive knowledge of IRS tax rules and regulations, so our work in completing your company’s 409A valuation will be accurate and in compliance.
Comprehensive Support and Compliance: ERB offers a complete, one-stop shop that handles all your financial needs associated with 409A compliance. Everything will be completed by ERB: Collection of necessary documentation; communication with third-party independent appraisers; and negotiations and filing of all associated ERB documentation with the IRS. You will eliminate the uncertainty and stress that can come from handling your 409A compliance in-house.