These days, a startup company should always have a current 409A valuation before granting stock options. Staying up to date with your company’s 409A valuation will allow you to award options to your workers faster, avoid problems during significant corporate transactions, and protect your company and its option holders from costly taxes and penalties. Read on to learn what a 409A valuation is, why it’s important, and how to get one.

Key Takeaways

• Section 409A of the Internal Revenue Code effectively requires companies to grant stock options with an exercise price equal to or greater than the underlying shares’ fair market value as of the grant date. 
• Options granted with an exercise price below fair market value can result in the option holder paying income taxes, interest, and penalties, which will practically wipe out any potential economic benefit from the option.
• Obtaining a third-party valuation of the underlying shares from a qualified, independent appraiser and using the appraised value to set the option exercise price is how startups can grant options without running afoul of Section 409A.
• A company’s 409A valuation report expires 12 months after the valuation date (which is not always the same as the report date) or when a material event affects the company’s value, whichever is earlier.
• Expect to get a new 409A valuation at least once every 12 months, or more frequently if your company is fundraising or reaching other significant milestones during that time.
• It typically takes two to six weeks for a company to engage a 409A valuation firm, provide necessary information, comment on a draft report, and finalize the valuation.

What Is Section 409A?

Section 409A of the Internal Revenue Code, and the Section 409A Treasury regulations, are U.S. federal tax laws and regulations that cover the taxation of non-qualified (meaning, not qualified under ERISA) deferred compensation plans. Non-qualified deferred compensation plans include stock options, which we cover in this post.

Section 409A effectively requires companies to grant stock options with an exercise price (or strike price) equal to or greater than the underlying shares’ fair market value as of the grant date. Options granted with an exercise price below fair market value can result in the option holder paying income taxes, interest, and penalties, which will practically wipe out any potential economic benefit from the option. If an option is underpriced, the company is also obligated to withhold income and employment taxes on the option if the option holder is an employee. If the company does not correctly pay these taxes, it may be required to pay interest and penalties on the amounts under-withheld.

How Is Fair Market Value Determined?

For a publicly-traded company, the fair market value of its shares is the price at which they are traded on the stock market. Since there is no liquid market for a private company’s shares, the company must determine fair market value for Section 409A purposes in other ways. Some of these methods, usually involving financial modeling, are more rigorous than others, like rules of thumb. 

The issue is that the Internal Revenue Service (IRS) can challenge a company’s determination of its fair market value. If the IRS does bring a challenge, it is usually the company’s burden to show that its value determination was reasonable. Fighting the IRS can be an uphill battle for a startup and usually requires significant time, back-and-forth correspondence, and accountants’ fees. 

However, the Section 409A regulations provide a few “safe harbor” valuation methods. If a company uses one of these safe harbors, the IRS will presume that the company’s determination of its fair market value is reasonable. Challenging a company’s safe harbor valuation requires the IRS to show that the valuation was “grossly unreasonable,” which the IRS is less inclined to spend its scarce resources doing.

Why Get a 409A Valuation?

Obtaining a third-party valuation of the underlying shares from a qualified, independent appraiser and using the appraised value to set the option exercise price is one of the safe harbors startups can use to grant options without running afoul of Section 409A. 

The appraiser will present its valuation of the company’s shares in a written 409A valuation report. After confirming that the appraiser’s methods are reasonable and that the report accounts for all relevant facts affecting the company’s valuation, the company’s board of directors can rely on the reported fair market value to set the exercise price of the company’s stock options.

A company’s 409A valuation report expires 12 months after the valuation date (which is not always the same as the report date) or when a material event affects the company’s value, whichever is earlier. Expect to get a new 409A valuation at least once every 12 months, or more frequently if your company is fundraising or reaching other significant milestones during that time. Many startup attorneys consider signing a term sheet for equity financing to be an event that causes the 409A valuation to expire.

Third-party 409A valuations are relatively cheap insurance against easily avoidable tax issues. A company that doesn’t use a valuation report to set its option exercise price will likely pay its accountants and lawyers significantly more than the cost of a third-party 409A valuation to deal with the resulting potential tax consequences in the middle of a financing or M&A transaction.

Why Not Use Another 409A Safe Harbor?

Sometimes a company will ask whether it can rely on the Section 409A safe harbor that allows an individual at the company with “significant knowledge, experience, education, or training” to perform a valuation of the company’s shares based on factors specified in the 409A regulations. The problem is that this other safe harbor’s requirements are too ill-defined and onerous. The pertinent rule says, in part, that “significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.” Practically, the people with this experience either (a) work at the third-party appraisers, or (b) could be better spending their time on pressing startup issues instead of deciphering the Section 409A regulations, writing a detailed valuation report, and potentially arguing to the IRS their qualifications to do so. Further, companies are only eligible to use this other safe harbor if they are less than 10 years old and are not anticipating a sale, IPO or change of control within the next 12 months. Startups are rarely certain about what will happen over the course of a year. Although limiting startup expenses is an admirable goal, it is usually less risky, more efficient and ultimately more cost-effective for a company to engage a third-party appraiser to prepare its valuation report.

How to Get a 409A Valuation

As of December 2020, early-stage companies should budget around $2,000 every 12 months for a new 409A valuation. Prices can range up to $10,000 for later-stage companies (Series B or later). Budget for an additional valuation if the company will be fundraising within the next 12 months because it will need a new valuation report after the fundraising. Prices for valuations can vary depending the stage of the company, the number of company stockholders, and even how quickly the company needs the valuation completed. Subscription valuation services, usually bundled with cap table management software, now exist to help companies stay current with their valuation reports.

It typically takes two to six weeks for a company to engage a 409A valuation firm, provide necessary information, comment on a draft report, and finalize the valuation. The company will need to provide an updated cap table, financial statements and projections, and schedule a call between the appraiser and company management. Keep this timeline in mind to avoid delays.

What Else to Know About 409A Valuations

Some founders worry that a 409A valuation, particularly one that comes back with a low fair market value, will negatively impact the valuation that an investor or acquirer places on their company. There is no need for this concern. Sophisticated investors and acquirers value companies differently and for different purposes than valuation firms. Investors and acquirers will care more that a company has been diligent in obtaining 409A valuation reports in connection with its option grants than about the value specified in the reports. Indeed, a lower 409A fair market value makes a company more attractive to employees and recruits because the company can grant its stock options with a correspondingly lower exercise price. This leaves more room for growth in the value of the shares. Experienced valuation firms recognize this and will work with companies, within reason, to arrive at lower, but still defensible, fair market values.