409a for Beginners: Simple Valuation Guide

Thousands of companies use equity compensation to attract and retain talent while also incentivizing employees to do their utmost for the company’s growth. But did you know that this tool which creates a win-win situation for both parties can actually only be used along with 409A valuations? Ignoring this requirement may lead to non-compliance with tax laws and penalties for your employees.

In this article, we will explore what 409A valuations are, and why they matter for startups. We will also briefly discuss important considerations such as safe harbor provisions and events that trigger 409A valuations. Read on to know more!

What exactly is a 409A valuation?

You need a 409A valuation to issue equity compensation in a tax-compliant manner. The purpose of such a valuation is to establish the fair market value (FMV), typically at the time of exercise or sale. By subtracting the exercise price from the FMV, we can find how much income an employee has made from a certain stock option. Thus, 409A valuations help stakeholders understand how much the startup is spending on employee compensation. However, the main utility of a 409A valuation is validating the income reported in tax filings made by employees.

The term fair market value (FMV) is very deliberate. A stock’s FMV is the price at which parties that know the company will willingly enter into a transaction under normal market conditions. Since we are assuming that these parties know the company, there cannot be any speculation built into the FMV.

Understanding the 409A valuation methodology is essential for startups to ensure compliance, accurately price employee stock options, make informed business decisions, and effectively manage risks associated with equity compensation.

Why should startups and founders care about 409A valuations?

If you do not get a 409A valuation when you issue equity compensation, you are exposing your employees to unsavory tax consequences such as penalties, immediate taxation on vested equity compensation, and higher-than-normal interest on unpaid taxes. This can drive a rift between you and your employees which can snowball into lawsuits.

Here, we must note that equity compensation can be quite instrumental for startups.

Conserving cash reserves is extremely important for startups and equity compensation lets you do so in your endeavor to attract the best talent for your team. Employee stock options represent a rare opportunity for most individuals to enter private equity, an asset class with high minimum investment amounts and high potential for growth, especially in startups.

Unless you need to offer share buybacks down the line, you should be able to reduce your cash outflow for employee compensation. Even if you must offer buybacks, you would still be able to defer your outflow for a few years.

However, cash conservation is not the only benefit of equity compensation. It also aligns the goals of your employees with the goals of your organization. Since the employees can actually receive higher profits if the company performs well, equity compensation motivates employees to contribute more.

The benefits of 409A valuations for founders are significant and multifaceted, impacting compliance, financial strategy, and employee relations.

To fully capitalize on the benefits of equity compensation, your startup should try to qualify for safe harbor status by getting a 409A valuation using one of three IRS-prescribed valuation methods. Companies must adhere to specific criteria established by the IRS to qualify for safe harbor status under Section 409A. Achieving this status protects the company from IRS scrutiny regarding stock option pricing and reduces the risk of penalties. 

When is a 409A valuation required?

409A valuations are required every 12 months or after a material event. Material events can significantly change your company’s value overnight and 12 months is enough time for a company to grow or devolve even in the absence of material events. Based on this rationale, your 409A valuation performed 12 months earlier or before a material event will be inaccurate and hence, cannot be used to issue equity compensation anymore.

Some examples of material events include changes in key regulations, major shifts in industry trends, funding rounds, and significant third-party share sales.

Several events can trigger the need for a 409A valuation, which is essential for determining the FMV of a common stock. By monitoring these 409A Valuation triggers, companies can ensure compliance with IRS regulations and maintain accurate valuations, which are crucial for effective equity compensation strategies.

What’s inside a 409A valuation report? A sample overview

In a 409A valuation report prepared by an expert, you will find:

• a summary of findings
• an explanation of the methodology and assumptions
• an industry overview
• an economic overview
• and results from each applicable approach

This is a very detailed report that helps you understand your company’s progress so far and any threats or opportunities it may be facing. Refer to Eqvista 409A valuation report example that includes all important sections essential for compliance with IRS regulations and setting the strike price for employee stock options.

Budgeting for Your 409A Valuation: Cost Insights

The cost of a 409A valuation depends on the complexity of the valuation. In the early stages, rudimentary financial models and valuation techniques will suffice since the operations of such startups are quite straightforward.

However, as a startup scales and goes through funding rounds, its operations and ownership structure will grow complex. Hence, advanced valuation techniques and extensive research are often required to value mid to late-stage startups.

Hence, the cost of a 409A valuation increases as your startup matures. It can vary significantly based on several factors that reflect the complexity and specifics of the company being valued. Typically, a 409A valuation costs $1,000 for early-stage startups and up to $10,000 for mature startups. However, Eqvista’s 409A valuation charges start from $990.

You must also note that you may require 409A valuations multiple times in a single year if you are expecting material events such as extensive revenue growth, introduction of new products, and entry into new markets. Hence, it is economical for startups to subscribe to annual subscription plans. Eqvista’s 409A valuation subscriptions start from $990 per year and go up to $4,290 per year.

409A compliance essentials for founders and CFOs

In order to save costs while qualifying for 409A safe harbor provisions, many startup founders and Chief Financial Officers (CFOs) try to value their startups using the illiquid startup presumption. You can only use this method if your startup is less than 10 years old and isn’t expecting any liquidity events in the next 180 days.

In addition to these requirements, this presumption also requires you to record your valuation process in a written form. Without accurate records and documentation, you run a higher risk of non-compliance, regardless of the 409A valuation method you choose.

The other presumption that founders and CFOs can use to perform 409A valuation is the binding formula presumption. However, this is the most restrictive route to 409A safe harbor status. It requires you to follow the same formula to value your company in all binding share sales, even the ones involving third parties. This can significantly limit the exit opportunities for your investors.

Ensuring tax compliance through 409A valuations is critical for private companies, particularly startups, that issue stock options or other equity-based compensation. Hence, startups usually go for the independent appraiser presumption to qualify for 409A safe harbor provisions.

Common Myths and Misconceptions About 409A Valuation

Some of the common myths and misconceptions related to 409A valuation are as follows:

• Required only when you issue stock options – Any kind of equity compensation, including restricted stock units (RSUs) and phantom stocks, warrants a 409A valuation. The goal of the 409A valuation is not to form a basis for setting the exercise price in a stock option but to establish the employee’s total income from equity compensation.
• Required only once a year – You must obtain a new 409A valuation whenever a material event occurs, even if less than 12 months have passed since your last valuation. Just a formality – Issuing equity compensation without a 409A valuation can create exorbitant tax liabilities such as tax penalties for your employees. If your employees believe you were negligent in performing 409A valuations, it may result in disputes that could snowball into lawsuits.
• Only needed for large companies – All American companies that issue equity compensation must establish their fair market value (FMV) using 409A valuations. Section 409A of the Internal Revenue Code (IRC) does not exclude any companies from this requirement on the basis of size.

By debunking these 409A valuation myths, startups can  process valuation with a clearer understanding of its requirements and importance in maintaining compliance and supporting their equity compensation strategies.

Take the first step towards mastering your company’s 409a valuation now!

To help your employees stay tax-compliant and avoid unsavory tax consequences, you must get regular 409A valuations based on appropriate methodologies and accurate data. This requires exceptional research and analytical skills, knowledge of tax laws and accounting standards as well as awareness regarding the latest developments in market trends, industry practices, and regulatory updates.

A 409A valuation expert analyzes a company’s performance through a systematic process that incorporates various methodologies and data sources.

Given the complexity and high-stakes nature of 409A valuations, most startups choose the independent appraiser presumption to attain safe harbor status. Even if you have the required skill set, spending weeks on a 409A valuation might not be the best use of your time. In contrast, a valuation expert like Eqvista can deliver an accurate 409A valuation in a matter of days for an affordable fee. Contact us to know more!