409A Refresh: What to Do Before Your 409A Valuation Expiration?

Suppose your company previously valued its stock at $10 per share on January 1, 2023. Following a Series A funding round on July 1, 2023, which valued the company at $20 million pre-money, the company conducted a 409A refresh. An independent valuation firm determined the new fair market value (FMV) to be $15 per share, effective August 1, 2023. This refresh allowed your company to issue stock options to employees at the updated FMV, ensuring compliance with IRS regulations and protecting against potential tax liabilities. 

Your company must probably conduct another refresh by August 1, 2024, or sooner if significant events occur. Depending on funding or specific material events, you may also require a 409A refresh before the 12-month term. 

This article covers when you’ll need one and how to safeguard your valuation using specific safe harbor methods. 

Importance of a 409A Refresh

The 409A refresh is essential to stay compliant and keep your startup’s finances in order.

“409A valuations have an expiration date”. — Yes, it is only valid for 12 months of issuing option grants at the set strike price. At the end of this time frame, your business must have a “409A refresh,” or an updated valuation, for maximum accuracy and compliance.

What happens when a 409A valuation expires?

When your 409A valuation expires:

• You can no longer legally issue stock options at the previously established fair market value (FMV)
• The company needs to obtain a new 409A valuation to set a new FMV for equity grants
• Any option grants made between 409A Valuation expiration and renewal may be non-compliant

Upon expiration of the 409A valuation, companies can no longer issue stock options at the previously established FMV, requiring a new valuation. Letting a valuation expire before obtaining a new one carries serious consequences, including tax penalties for employees, company liability, and loss of safe harbor protection. Companies should begin the renewal process 1-2 months before the expiration date to maintain compliance.

Factors that Trigger the Need for a 409A Refresh

Conducting a 409A refresh is essential for startups offering equity remuneration. This process ensures compliance with IRS regulations, avoids costly penalties, and provides safe harbor protection. A timely refresh ensures accurate stock option pricing, essential for retaining top talent through competitive equity compensation. During business transitions, it accurately captures changes in the company’s value, ensuring that financial reporting remains robust and reliable.

Here are several factors that trigger the need for a 409a valuation refresh:

• Annually: You must update your 409A valuation yearly, even if your company has not experienced many changes. It tracks the value of your business over time and ensures that you remain compliant, which can prevent future issues.
• After material events: A startup’s worth may rise after it launches a new product or reaches a significant milestone. On the other hand, failing to meet a deadline or switching to a different business plan could negatively affect the startup’s worth and necessitate another valuation.
• When approaching the 12-month expiration: To stay compliant with IRS regulations, companies should initiate the renewal 1-2 months in advance to ensure compliance. Failing to obtain a new valuation before 409A valuation expiration prevents legal issuing stock options at the previous fair market value and exposes employees and the company to significant risks. By treating 409A compliance as a routine business rather than a one-time event, companies can avoid the problems of letting a valuation expire.
• Before a new round of option grants: If you intend to issue another batch of stock options, you must first get a fresh 409A. This means you’re awarding options at the most recent fair market value, which supports the fairness of your equity compensation scheme.
• When engaging auditors: Investors often expect you to start delivering audited financials once you achieve roughly $10 million yearly revenue for most businesses. Your auditor will examine the valuation since it is a significant factor in determining stock compensation expense. 
• In preparation for an IPO: Management considers several valuation outcomes when considering an initial public offering (IPO), merger, or acquisition. Upon reaching a specific exit probability, a fresh 409A valuation becomes necessary. It shows regulators and possible public investors that it is a consistent financial diligence and compliance model. 

Step-by-Step 409A Refresh Process

The 409A refresh process is essential for private companies to ensure compliance with IRS regulations regarding the fair market value (FMV) of their common stock.

1. Identify when your 409A valuation approaches expiration

A refresh is needed annually to maintain compliance and safe harbor status with the IRS. If major events occur, such as funding rounds, mergers, acquisitions, or operational changes, a refresh is required sooner than the annual deadline.

2. Select a Valuation Firm

Choose an independent third-party valuation firm experienced in conducting 409A valuations for companies in your industry. Ensure the firm is qualified to provide a defensible valuation that meets IRS safe harbor requirements.

3. Gather Necessary Information

Provide the valuation firm with detailed financial data and share details about any material events or changes in the company’s operations or market conditions.

4. Conduct the Valuation

The valuation firm will apply appropriate methods to determine the FMV of your company’s common stock. Common methods include:

• Market Approach
• Income Approach
• Asset-Based Approach

5. Review and Implement the Valuation

The valuation firm will provide a report of the FMV of your company’s common stock. Update your company’s records and use this updated value for any future stock option grants to ensure compliance with IRS regulations.

Costs and Timing for 409A refresh

409A valuation costs can vary, ranging from $2,500 to $10,000 and more. They mostly depend on the complexity of the valuation and industry standards. They also vary based on several factors, including the company’s stage, size, complexity, and valuation provider.

Eqvista offers more affordable options, which provide valuations starting at $999 for subscribers.

To ensure timely compliance, start the refresh process about a month before the current valuation expires. This allows enough time for data collection, analysis, and board approval. The time required to complete a 409A valuation can vary based on factors like company complexity, client responsiveness, and the efficiency of the valuation firm.

The process typically takes 6 to 12 weeks; Eqvista can complete the valuation in as little as 5-10 days and offers expedited services that can complete the valuation in 3-5 days.

Risks of Not Completing a 409A Refresh On Time

Not completing a 409A refresh on time can expose both the company and its employees to significant risks and penalties. Here are some of the potential risks:

Tax Penalties for Employees

If stock options are granted at an outdated FMV, employees may face immediate taxation on the difference between the outdated FMV and the actual FMV at the time of vesting. Employees may be subject to a 20% federal penalty on the deferred compensation and interest charges. Additional state penalties may apply, increasing the financial burden on employees.

Legal and Reputational Risks for the Company

Failure to maintain accurate valuations can lead to costly legal challenges if employees are unexpectedly taxed. Companies may suffer reputational damage if they fail to protect employees from tax liabilities, potentially impacting talent retention and recruitment.

Loss of Safe Harbor Protection

Without a timely 409A refresh, companies make them more vulnerable to IRS audits and challenges. Without safe harbor, the company bears the burden of proving the valuation’s reasonableness, which can be costly and time-consuming.

Impact on Investor Confidence and Fundraising

Investors value companies that maintain accurate and compliant financial practices. Failure to do so can raise concerns about financial management, potentially hindering fundraising efforts. Investors may not be ready to invest in companies with compliance issues.

Employee Dissatisfaction and Talent Retention Issues

Employees facing unexpected tax liabilities may become dissatisfied and leave the company, impacting talent retention and business continuity. Inability to offer competitive equity compensation due to outdated valuations can make it harder to attract and retain top talent.

Safe Harbor Protection

A 409A valuation must be refreshed at least once every 12 months to maintain “safe harbor” status, which protects companies from IRS penalties related to stock option pricing.

This refresh makes sure that the fair market value (FMV) of a company’s stock is compliant with IRS regulations. 

The safe harbor allows the valuation to be reasonable if conducted by a qualified appraiser and within the specified timeframe, minimizing the risk of IRS challenges. A refresh is required whenever any significant events occur such as new funding rounds or changes in business operations.

Methods to Obtain Safe Harbor Status

Obtaining safe harbor status can vary depending on the context; it involves meeting specific requirements or using designated methods to comply with regulations and avoid penalties or liabilities.

Independent valuation

The quickest and most reliable way to obtain safe harbor is to hire a third-party, independent 409A valuation service — and it’s also the most popular.

• How it works: To perform the 409A valuation, you need an impartial, certified appraiser like Eqvista. It is, therefore, assumed that their appraisal is fair. If the IRS wants to disprove that assumption, they must show that the valuation was “grossly unreasonable.”
• Ideal for: Organizations looking for the maximum valuation certainty.
• Pros: Guaranteed acceptance by the IRS; offers effective defense during audits.

Illiquid Startup Presumption

This is for startups not anticipating an IPO within 180 days or a change of control within 90 days. Valuation must be done by a “qualified individual” with 5+ years of relevant experience.

• How it works: This presumption applies to start-ups under ten years old that do not have a public offering or change in ownership within the next twelve months and are not publicly traded. Someone with extensive expertise in comparable valuations or relevant work experience must conduct the valuation.
• Ideal for: Only early-stage startups with fewer than ten years of experience and no financial history can use this approach.
• Pros: It is economical.

Binding Formula

This method uses a consistent formula for all stock transfers. However, businesses rarely use it due to its inflexibility.

• How it works: This approach commonly uses a multiple of earnings or some other financial statistic as the basis for an internal valuation formula. The formula may become outdated or not accurately reflect the market’s state. Therefore, it needs to be logical and justifiable.
• Ideal for: Businesses that often use the same approach for other business values, such as buy-sell agreements.
• Pros: It helps ensure that company valuations are consistent with one another.

FAQs

Here are some commonly asked FAQs about the 409A refresh process:

How does a 409A refresh impact stock option grants?

A 409A refresh ensures that stock options are granted at or above the current fair market value of the company’s common stock. This is necessary for maintaining compliance and ensuring that employees receive fair equity compensation.

Can a company perform its own 409A valuation?

While possible, it is generally recommended to hire an independent third-party firm to conduct the valuation. This ensures objectivity and helps maintain safe harbor status with the IRS.

Are there any specific industry standards for selecting a 409A valuation firm?

While there are no strict industry standards, it is advisable to choose a firm with experience in your industry and a track record of providing defensible valuations that meet IRS safe harbor requirements.

Can a company delay a 409A refresh if it is close to a major funding round?

Delaying could lead to penalties if stock options are issued at an outdated valuation. It is recommended to conduct a 409A refresh before a funding round to ensure compliance and safe harbor status.

Get Your 409A Valuation Done With Eqvista!

Conducting a 409A refresh is vital not only for legal compliance but also for strategic business management, ensuring that both the company and its employees are protected from potential tax liabilities while fostering growth and investment opportunities.

You must have an independent 409A valuation to avoid any challenges with the IRS and stay in compliance. Granting safe harbor status guarantees reasonable and equitable stock option pricing.

Eqvista provides expert valuation services for businesses of all sizes and sectors. Our NACVA-certified team uses tried-and-true methods to produce reports ready for audits. We provide:

• Unlimited valuations for 12 months
• Dedicated analysts for each case
• Expertise across various sectors
• Affordable pricing for high-quality reports

Need a reliable 409A valuation? Contact Eqvista today for a consultation.