Posted by Shivali Anand
May 9, 2022 | 4-minute read (663 words)
Equity-based compensation is a popular tool for startups and privately held businesses to recruit talent and reward staff for their contributions. Startups intending to offer stock options to employees or founders must first determine the actual market value of one share of common stock in the firm, according to section 409A of the U.S. Internal Revenue Code.
Startups use a 409A valuation to offer common stock or options to workers at a discount while ensuring that the strike or exercise price is equal to or more than fair market value, preventing beneficiaries from incurring a tax liability. For a privately held company, the 409A valuation is the only method that can be used to grant options on a tax-free basis to employees. Otherwise, taxes will be assessed based on the spread between the fair market value and the exercise price of the options
Current fair market value refers to the price per share at which new employee options will be offered. For instance, if you are an employee of a business with a current 409A price of $1, your options will have a strike price of $1 per share.
The IRS issued the 409A section of the IRC in 2005 in response to the prevalence of Silicon Valley awarding stock options during the dot-com boom. The agency wanted to ensure it received its fair share of taxes on noncash components of employee remuneration.
When is a 409A valuation required?
To avoid tax penalties, every business intending to issue common stock to employees must conduct a 409A valuation. The 409A evaluation is valid for 12 months or until the firm undergoes a material change that impacts its value, typically a financing event.
Why is a 409A valuation required?
Conducting the 409A valuation potentially saves companies tens of thousands of dollars in tax penalties in the event challenges arise from the IRS. By obtaining the valuation, the IRS operates under the presumption that the valuation is correct, and it is therefore up to the IRS to prove it was incorrect.
Who can perform a 409A valuation?
It is preferable to hire an experienced third party who is independent of the business. However, no single body oversees the valuation profession. When you speak to a potential appraiser or valuation firm, be sure they have ample experience with 409A valuations in your startup’s sector, because the purpose of the 409A is to support a tax position.
Alternatively, someone at the company issuing nonqualified deferred compensation instruments may undertake a 409A valuation, but the method they use must be grounded in established principles and based on recognized standards. Certain cap table software systems also include valuation services as an add-on.
How is the 409A calculated?
Experts in 409A valuation maintain that the process is inherently subjective and that valuations are part art, part science. By hiring a third-party valuation expert, you are paying for an opinion that is defensible but also subjective.
There are three main methods for performing the 409A valuation. Under the asset approach, liabilities are subtracted from total assets; however, this approach is more common with capital-intensive businesses. Other approaches include the income, or cash flow outlook method, and the market approach. The latter is the most common among startups and is based on comparable valuations in the market.
The fair market valuation is not derived by simply dividing the valuation by the number of outstanding shares because there are different types of shares. Each class of share has to be evaluated independently, and a value must be assigned to each of those different classes.
How long does a 409A valuation take?
The time required to conduct the 409A valuation depends on its complexity and the amount of analysis it requires. Early-stage companies are usually more straightforward and will likely require a 10 business day turnaround. For companies at the Series B stage, the valuation may take about 15 business days. Businesses on the verge of an IPO or acquisition will take longer.