Apparently, compliance and 409A valuations are not the most fascinating parts of being a founder, but they are very important to a company’s long-term success. Here, we are going to explain what a 409A valuation is, what a 409A valuation is used for, and other information related to 409A valuation.
What is a 409A Valuation?
What is your company worth? For public companies, usually that value is set by the market. On the other hand, private companies depend on independent appraisers. Please enter the IRS Section 409A valuation. Need to know that a 409A is an independent appraisal of the Fair Market Value (FMV) of a private company’s common stock, or the stock reserved for the founders and the employees. This valuation 409A will determine the cost to buy a share. Long story short, you will not be able to offer equity without knowing how much a share is worth. So, if you want to offer equity, you will need a 409A valuation.
What is a 409A Valuation Used for?
First, it is crucial to distinguish between a 409A valuation and a valuation set by the investors during fundraising.
You have to know that A 409A is used to determine the Fair Market Value (FMV) of your company’s common stock. Usually, it is determined by a third-party valuation provider. 409As will set the strike price for options issued to the employees, advisors, contractors, and anyone else who gets common stock.
A 409A valuation is often different from a company’s post-money valuation that is based on how much investors paid for their ownership stake during a fundraising. The investors are going to get preferred stock, so a post-money valuation is based on the price of preferred shares, while a 409A is a valuation of your common stock. Usually, preferred stock has certain attributes which make it more valuable than common stock.
409As, which refer to the Internal Revenue Code Section 409A, are managed by the IRS. To take advantage of the IRS safe harbor, then the 409A valuations should be done annually or each time the firm has a material event, like a new financing.
What is IRC Section 409A?
In response to the Enron scandal in 2001, regulators looked for ways to prevent executives from taking advantage of equity loopholes. In the year 2005, the IRS introduced Section 409A, and then finalized it in the year 2009. The 409A makes a framework for private companies to follow when valuing private stock. When the valuation is conducted by an independent party, it will establish a safe harbor, meaning that the 409A is presumed to be reasonable by the IRS.
Valuation is not something that you take lightly. When your company does not obey the 409A rules, and the equity is mispriced, then the IRS will be able to assess penalties. Who ends up paying? Usually, the employees and the shareholders.
What is 409A Safe Harbor?
When your 409A is handled in a specific way, then it is eligible for “Safe Harbor” status. A safe harbor valuation is one the IRS presumes to be valid unless they are able to show that it is grossly unreasonable.
Apparently, the IRS gives three safe harbor methods for setting the FMV of private company common shares:
- Independent appraisal presumption
- Binding formula presumption
- Illiquid startup presumption
You have to know that the most common approach to reaching 409A Safe Harbor status is using the independent appraisal presumption, or in other words, using a qualified, third-party appraiser.
A 409A valuation is assuredly reasonable if the stock was valued within twelve months of the applicable option grant date and also no material change has occurred between the valuation date and the grant date. If those requirements are met, then the burden is on the IRS to prove the valuation is grossly unreasonable.
The 409A Safe Harbor May Protect You from IRS penalties
While the companies often run their financial analysis to determine Fair Market Value (FMV) very early on in the company’s lifecycle, over time, those valuations become more difficult. They will need more expertise, and also take more time. Do not worry, third-party, independent valuation providers like Carta will be able to help make sure you have a 409A on file. It will be able to protect common shareholders from certain IRS penalties.
To take advantage of IRS safe harbor, your company must have completed an acceptable 409A valuation in the last twelve months. If your company has not completed an acceptable 409A valuation, or if the IRS determines that your valuation is very unreasonable (and thus your option grants were not issued at fair market value), option-holders were able to be impacted.
Here is what could occur to the employees who received incorrectly priced options:
- They were able to be taxed on those options immediately.
- They were able to be fined an additional 20 percent of the value of their option grants and probably have to pay other penalties as well.
You Will Need a New 409A Every Year or Each Time A Material Event Happens
Here is a summary of events which trigger a new 409A valuation:
- In general, you have to get your first valuation before you issue your first common stock options, usually to your first hire or advisor.
- Also, you will need a new valuation after raising a round of venture financing, because the previous 409A becomes obsolete after the new round is raised.
- You have to get a new valuation every 12 months or if there is a material event which impacts the value of the company, to continue to take advantage of 409A IRS safe harbor. Remember that a material event is an event which could reasonably be expected to affect a company’s stock price, like another financing round.
How Much Does a 409A Cost?
We get information that several providers offer standalone 409A valuations. Other providers offer bundled services. For standalone valuations, the cost ranges from $1,000 to over $10,000, depending on the size and complexity of your firm.