What is 409a Refresh?
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
“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.
The 409A refresh is essential to stay compliant and keep your startup’s finances in order.
Here are a few more reasons to get a refresh done:
- Compliance with IRS regulations – Timely 409A updates guarantee compliance with IRS regulations. Compliance with this requirement is mandatory for startups that offer equity remuneration and cannot be waived.
- Avoidance of penalties – Not keeping accurate valuations is associated with steep fines. Employees with vested options may be subject to immediate taxation, a 20% federal penalty, and possible state penalties.
- Safe harbor protection – A 409a refresh shows that your valuation is up-to-date and makes it eligible for safe harbor status. So, when your valuation is questioned, this legal protection shifts the burden on the IRS to prove it.
- Accurate stock option pricing – With a 409A refresh, your stock options will be priced fairly. This is significant in attracting and retaining talented employees through competitive equity remuneration.
- Investor confidence and fundraising – Investors value financial responsibility. Keeping your 409A up-to-date will demonstrate that you are managing your funds well, which can help discussions about fundraising go smoothly.
- Material events – Major business transitions that affect your company’s value include new product releases or new investments. A refresh will accurately capture these modifications.
Here’s a look at the potential costs of neglecting the 409A refresh
| Consequence | Potential Cost |
|---|---|
| IRS Penalties | 20% federal tax + interest |
| Employee Dissatisfaction | Loss of key talent |
| Investor Hesitation | Delayed or lost funding |
| Legal Challenges | Costly litigation |
Factors that Trigger the need for a 409A refresh:
Here are the 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: Your 409A valuation has a 12-month validity limit. As you approach this expiration date, starting the refresh procedure is advisable. To guarantee continued coverage, begin the process approximately one month before expiration rather than waiting until the last minute.
- 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.
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
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.
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.
