The Authoritative Guide to 409A Valuations
Whatis a 409A?
A 409A valuation is a formal report that tells you the value of your company’s common stock. When you give stock options to your employees, you are giving them the option to buy equity in your company in the future at a price (the “strike price”) that is determined today.
The number one purpose of a 409A is to set your option strike price, for option grants and warrants. This has a major impact on your new hires because this is the price they will pay to buy their options, and the difference from the Fair Market Value (FMV) determined in the 409A when an employee joined and the company’s current FMV is how much an employee will pay in taxes when they exercise.
When you issue options to employees, the strike price (the price that you pay to exercise an option) must not be below the current value of common stock. If you offer options at a strike price that is below the current value of the common stock, you and your employees could incur severe tax penalties.
409A valuations are a thorn in every founder’s side. They are expensive (although getting cheaper) and since they attempt to value a pre-revenue company in a disruptive market —they often feel like black magic. That said, 409As are a legal requirement by the IRS.
When to get a 409A:
There are a few simple rules for getting a 409A valuation:
You should get your first 409A when you make your first employee hire so that their options are priced.
You should get a new 409A every year after your first 409A to maintain safe harbor.
You should get a new 409A every time you complete a fundraise, which is a material change in your business.
You should get a new 409A when your company goes through a material change. Note these types of changes outside of fundraises are uncommon but include mergers, acquisitions, or in some rare instances making a game-changing executive hire.
The cost of a 409A:
The cost of 409As is dropping rapidly. Back in 2005, when the IRS first passed its new ruling requiring private companies to get 409As, the average price was $25,000. This puts a significant burden on small startups. Now as valuation firms have gotten more efficient and as companies like eShares have leveraged technology in their valuation process, the price has dropped to only a few hundred of dollars for early-stage companies and a few thousand for later stage companies.
Final thoughts:
When your company gets a proper 409A from a third-party valuation service, you will receive safe harbor. Safe harbor means that your company has completed an acceptable valuation in the last year and is protected from having to prove to the IRS that your valuation is accurate. 99% of the time this valuation is done by a 3rd party because in some rare cases (if you’re an illiquid company, under 10 years old) you can gain safe harbor from having an internal employee with adequate accounting experience do the valuation (we rarely if ever see companies go down this road).
If your company doesn’t have safe harbor and the IRS deems the strike price on the option grants you have given out to be inappropriate, your employees will be taxed immediately on the options they have already received, plus a 20% penalty, plus other fines. Obviously, this is a liability you don’t want to have.
eShares and Dreamit Ventures partner to offer the eShares equity platform and valuation services at a significant discount to startups. Go here to learn more! This post was written by Nathan Parcells.