What is a 409a valuation?

Definition and Example of 409a Valuation

Private companies that wish to issue shares to their employees need an evaluation. Unlike public companies, stock prices are not available for viewing at any time. This type of valuation is called 409a valuation.

Note: If you fail to obtain a 409a valuation, your company may face issues with the Internal Revenue Service (IRS) and cause headaches for your employees.

There are many reasons a company may want to offer shares to employees. For example, new companies may offer a significant amount of stock to their employees as an incentive. Owning a piece of the company helps employees truly invest in their work. Stock options can also be a good way for an early-stage company to compensate employees if they cannot immediately pay higher salaries.

Regardless of the reason, any company that wishes to offer shares to employees must obtain a 409a valuation. This should be done every 12 months or with each funding round.

How Does 409a Valuation Work?

To understand 409a valuations, it helps to understand how private companies reward employees with stock options. Here’s an example of how it works:

Company A hires a new employee and offers them the option to purchase 1000 shares of stock at the current fair market price. Let’s say each share is worth $1 at that time. This price is known as the “strike price.” Company A tells the employee that they can “exercise” this option after five years of working at the company. This is known as the “vesting period.” The vesting period can vary among companies. Five years pass, and the shares are now worth $30 each. The employee exercises their option to buy 1000 shares at $1 per share. Essentially, they are paying $1000 for something worth 30 times that. The employee can either hold onto the shares or sell them for $30 each, making a profit.

409a valuations are crucial for this situation to determine the price of the option offered to employees. The IRS does not want companies to simply value themselves at an arbitrary amount. While employees certainly want to purchase shares at the lowest possible price, if your company values itself too low, it might be accused of offering stock options at too cheap a price as a means of hiding income.

Note: Section 409a of the tax code does not explicitly define “fair market value.” It is defined by other provisions of the law as the price at which the company would be bought and sold.

How to Obtain a 409a Valuation?

The recommended method for conducting a valuation is to hire an outside firm. This group can determine the fair market value by examining the company’s financial data. The team may analyze the company’s cash flows, assets, or both. They may also conduct comparisons with similarly sized companies in similar industries.

There are software programs that help you determine the fair market value yourself, which may save money for your company. However, doing so is riskier than hiring an outside firm, as you may not qualify for what is called “safe harbor.” If you obtain safe harbor, the IRS is obligated to accept your valuation unless it can prove it is unreasonable. The burden of proof is on the IRS. Generally, obtaining safe harbor status is difficult unless the valuation is conducted by a qualified third party.

Hiring an outside firm to perform your 409a valuation can take about a month. Running the actual report may take a few weeks, and you should consider the time needed to gather the necessary data and any necessary revisions.

Does

I need a 409a valuation?

Suppose your startup company is eager to issue stock options to employees and is bypassing the 409a valuation process. Instead, you are guessing what a reasonable price per share might be.

If your company is audited by the Internal Revenue Service, you may find yourself in serious trouble. Employees could face immediate taxation at ordinary income rates on all vested options, along with a potential 20% penalty. There may also be additional state penalties, interest on unpaid taxes, and other fees.

In short, obtaining a 409a valuation is a crucial step for a company looking to begin compensating employees through stock options. You can proceed knowing that you are in compliance, and consider it a rite of passage for your company as it grows.

Source: https://www.thebalancemoney.com/what-is-a-409a-valuation-and-should-your-company-have-one-4171744