7 Things You Need to Know About 409A Valuation

Is your startup planning to offer stock options to employees? Then getting a 409A valuation is essential.

If your company is planning to offer stock options to employees or contractors (as my new startup is), then you’re going to need a 409A valuation.

Never heard of a 409A valuation? No problem.

Here are seven things you need to know about a 409A valuation.

1. What Is a 409A Valuation?

Essentially, a 409A valuation is an appraisal of the fair market value of your startup company’s common stock.

With publicly traded stock it’s easy to see the specific prices for any given time of day. But for private company stock, you need an independent valuation to see how much your company stock is worth.

The 409A name comes from IRS Section 409A. Added as part of the American Jobs Creation Act of 2004, it states:

Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.

Stock options are considered deferred compensation. A 409A valuation will determine a “strike price” (the price at which your employees can buy equity in your company) that must be at or above fair market value.

2. Why Do You Need a 409A Valuation?

Simply, a 409A valuation is required by law. You need a 409A valuation to ensure your company is in compliance.

Non-compliance can have terrible consequences. Undervaluing stock options can result in major IRS penalties and lost compensation.

3. When Do You Need a 409A Valuation?

If you plan to offer common stock options, then there are two times you must get a 409A valuation.

• Every 12 months.
• Anytime your company closes a new funding round.

4. What Factors Influence Your 409A Valuation?

Essentially, a 409A is an appraisal. To determine this, firms will generally take one of the following approaches to appraise fair market value:

• Market approach: An analysis of comparable private and public companies and transactions.
• Income approach: An analysis of a company’s free cash flows to determine projections for the next five years.
• Asset approach: An analysis of a company’s tangible and intangible assets.

5. How Do You Get a 409A Valuation?

You have three options to get a 409A valuation report:

• Do it yourself. This is the riskiest option of the three because there is no “safe harbor” protection should the IRS get involved. That means you have to prove that your valuation is correct. Although you might save money doing it yourself, you might also make mistakes. Unless you have the expertise and education needed to do a 409A, leave it in the hands of a professional.
• Use software. This is equally risky. Only certain early-stage startups are eligible to do this (e.g., you don’t have consistent revenue, you haven’t raised $500,000, you’re not within 180 days to an IPO or 90 days to acquisition, you have less than $100,000 in assets).
• Hire a firm. Paying for a 409A is the least risky option because it offers safe harbor protection. That means now the burden of proof is on the IRS (rather than you) to show that your valuation is too low. You’ll need to find a knowledgeable and experienced independent firm that has the right education and also a good reputation.

6. How Long Does the 409A Valuation Process Take?

Here’s what a typical time frame is when dealing with a valuation firm, according to Capshare:

• Hand over your data (1–3 days): This will include your cap table, articles of incorporation, financial projections, term sheets, and past 409A reports.
• Run the report (10–20 days): If you want your valuation quicker, expect to pay at least $1,000 to $3,000.
• Review first draft (15 min-1 hour).
• Revisions (1–2 days).
• Final report is delivered (1–10 days).

7. What Happens if You Don’t Have a 409A Valuation?

It can be really bad if you don’t price your stock options because the IRS sees that as giving away something valuable. This can cause major tax issues.

Any option holders discovered to be in violation of 409A will have to pay taxes plus a 20 percent federal penalty, any applicable state penalties, an IRS tax underpayment penalty, and any interest on unpaid taxes.

Most startups likely won’t face a 409A audit from the IRS. But if your startup becomes successful and starts making money, an IRS audit becomes a greater possibility. This will be expensive and time consuming.

In addition, you’ll likely face serious questions from the Securities and Exchange Commission, which looks closely at pre-IPO stock awards.

So protect your company and your employees. Get a 409A valuation.

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About The Author

Larry Kim is the CEO of Mobile Monkey and founder of WordStream. You can connect with him on Twitter, Facebook, LinkedIn and Instagram.

Originally published on Inc.com