As an entrepreneur or founder, valuation of your company is something that you are always thinking about. But you may have heard something about a 409A valuation and are wondering what is a 409A valuation? How frequently does a 409A valuation need to be performed? Well, this page will discuss that topic.
What is a 409A Valuation?
Need to know that a 409A Valuation is an appraisal of the Fair Market Value (FMV) of the common stock of a private company by an independent third party. Usually, startups pay for those assessments. Then, it uses the findings to inform the price at which the employees are able to purchase shares of the company’s common stock. For your information, common stock is the portion of a company’s stock reserved for the employees and the founders.
When is the Right Time to Get a 409A Valuation?
Actually, the right time to get a 409A Valuation depends on the events at your company such as fundraising, or hiring the employees paid with equity. If you get a 409A valuation too early, you are going to expend scarce early-stage capital on a service which will likely make unnecessary inconvenience. In other cases, if you get a 409A valuation too late, you are going to risk selling underpriced options that can give you serious fines from the IRS.
How Often Do You Need a 409A Valuation?
A 409A Valuation is frequently different from a company’s post-money valuation. It is based on how much the investors paid for their ownership stake during fundraising. The investors get preferred stock. Therefore, a post-money valuation is based on the price of preferred shares. While a 409A is a valuation of your common stock. Preferred stock typically has particular attributes which make it more valuable than common stock.
So, how often do you need a 409A Valuation? To take advantage of the IRS safe harbor 409A valuations should be done annually, or each time your company has a material event, like a new financing.
How Do You Know You Need a 409A Valuation?
Apparently, there are two occasions when you have to get a 409A Valuation:
- When you start planning stock options.
- When your firm undergoes a material event.
Here is a rundown of each:
- Getting a 409A Valuation when you start planning stock options
Your firm is new, you have great co-founders with amazing ideas, and you are ready to start building. Problem is, you do not have a lot of spare cash for hiring talent. Do not worry. Offering stock options will attract the employees to your startup and incentivize them to assist you succeed long-term. But, if you manage your new employee with a stock option plan, and the strike price is lower than what the IRS later deems acceptable, they are able to get dinged.
At least, they are going to be forced to pay a 20 percent penalty on their valuation. That is on top of any taxes owed on the difference between the strike price they paid and what is deemed an appropriate fair market value. When you start planning to hire a workforce and compensate for them with stock options, it is time to get a 409A valuation. Doing so will save you and your employees.
- Getting a 409A Valuation when your company undergoes a material event
Need to know that a material event is anything which changes the value of your firm. That includes:
- Qualified financing rounds. For example, you sell common shares, preferred stock, or convertible debt to outside investors.
- A merger with another firm.
- Acquisition of another firm.
- Acquisition by another firm.
- Secondary sales of common stock.
- Major changes to your business model/ financial projections.
It is very crucial to get a 409A after any one of those material events, but particularly after a qualified financing round. After the investors have funded your firm, its value has changed.
After you get a 409A Valuation, it is good for twelve months after the valuation date. It means that every 409a valuation is good for a year. You are able to mark it on your calendar right now, just because you have done a 409A Valuation does not mean you are in the clear.
For those who plan on issuing more common stock, you will need to get another valuation. If your firm has not undergone any material changes, you are able to go past the 12-month mark, meaning your previous 409A has expired. However, at this point, you are leaving 409A Safe Harbor. Your safest bet is to get a new 409A after twelve months have elapsed, or after a material event.
Why Do You Need a 409A Valuation?
Keep in mind that private companies need a 409A valuation to offer equity to the employees on a tax-free basis. The term 409A valuation comes from Section 409A of the United States tax code that regulates non-qualified deferred compensation plans, for example: Stock options. The regulation requires the private companies to determine an exercise price, the price at which employees are able to buy shares of their common stock after the shares have vested, of their stock which never be less than the FMV of the underlying stock on the date the stock right is given.
A 409A Valuation is required because the value of a private company’s common stock is not readily available because it is not listed on a public stock exchange. The IRS has issued regulations which need a reasonable method to determine Fair Market Value (FMV) at the time of grant. Using an independent third party to determine the Fair Market Value (FMV) of a company’s common stock every twelve months is one great way the company makes sure the value of the stock is considered to be reasonable by the IRS. This reasonable valuation method will establish what the IRS calls a Safe Harbor for the company.
Without a valuation Safe Harbor, the company will be subject to a big and hefty tax penalty. A valuation considered unreasonable by the IRS would result in all deferred compensation for the employees from the current and previous years becoming taxable immediately with an additional 20 percent tax penalty.