409A Valuations — from The Holloway Guide to Equity Compensation

The following excerpt is from The Holloway Guide to Equity Compensation, a detailed reference with hundreds of resources on stock options, RSUs, job offers, taxes, and more. You can read more from this excerpt, or access the full guide text at holloway.com.

THE FULL VERSION OF THIS GUIDE ANSWERS QUESTIONS LIKE:

What is a 409A valuation?

How is a 409A valuation calculated?

How often is a 409A valuation needed and how long is it good for?

What is the difference between a company’s 409A valuation and its “fair market value?”

When an employee’s stock vests or he or she exercises an option, the IRS determines the tax that person owes. But if no one is buying and selling stock (as is the case in most startups) then the value of the stock — and thus any tax owed on it — is not obvious.

The fair market value (FMV) of any good or property is a price the buyer and seller have agreed upon when both parties are knowledgeable, willing, and not under direct pressure to carry out the exchange. The fair market value of a company’s stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a company’s stock is determined by the company’s most recent 409A valuation.

A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS won’t consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events, like fundraising. The 409A valuation of employee equity is usually much less than what investors pay for preferred stock; often, it might be only a third or less of the preferred stock price.

Even though the 409A process is required and completely standard for startups, the practice is a strange mix of formality and complete guesswork. It has been called “quite precise — remarkably inaccurate,” by venture capitalist Bill Gurley. You can read more about its nuances and controversies.

… read more from this excerpt to learn even more about the 409A process