How Does a 409A Valuation Affect Stock Options?

Offering stock options is one of the most valuable incentives startups can provide employees, to stay relevant in a competitive recruitment landscape. The promise of stock options enhances the overall employee value proposition (EVP) in a scenario when a startup simply cannot compete with higher compensation packages. However, before issuing stock options, Internal Revenue Service (IRS) guidelines require that companies get a 409A valuation done by an independent appraiser. This is an important safeguard for both employees and the business.

Potential hires view stock options as an opportunity for a larger stake in the business, and a way to generate long-term wealth. For instance, employees of GoDaddy, Intuit, Aflac, The Cheesecake Factory, and Cadence, deeply benefitted through stock options when the businesses became publicly-traded companies.

However, the journey to successfully offering stock options involves some important compliance measures. An important one is for businesses to have a 409A valuation done by a third-party appraiser.

What is a 409A Valuation?

According to IRS guidelines, companies must commission an independent third-party appraiser to do an independent valuation of the fair market value (FMV) for the company’s common stock. Common stock refers to the stock reserved for founders and employees of the business. Startups must fund the assessment themselves and then use the recommendations to set the price at which employees can purchase shares from the company’s common stock pool.

Benefits of 409A Valuation 

Taxation is a key concern for startups and their employees regarding stock options. With a 409A valuation, a startup can offer stock options on a tax-free basis by issuing them at the recommended FMV. If they are issued at a price lower than the FMV, then employees could end up paying the penalty through taxes at a later date.

To arrive at the right FMV, the 409A valuation must be undertaken as a rational exercise, and the recommendations must be realistic. The valuation must be logically defensible and not influenced by inflated market projections.

To understand the importance of this step, we need to understand the genesis of the 409A valuation. The IRS passed Section 409A as part of the 2004 American Jobs Creation Act after energy corporation Enron overstated the value of its business, only to declare bankruptcy in 2001.

409A Valuation vs Finance Round Valuation

Some founders and startups may confuse the 409A valuation with the type of valuation made during a fundraising round. However, both serve very different purposes, and their significance is unique.

The price of preferred shares determines a fundraising valuation. Preferred shares are those stock options owned by investors who have paid a significant amount for an ownership stake in the business. Hence, the preferred stock is considered to be of much higher value than the common stock. Secondly, how much an investor agrees to pay for their stake is driven by market demand.

Potential investors observe how companies approach their 409A valuation. It can say a lot about a company’s approach to aspects like compliance and transparency in building a sustainable, profitable business with a long-term horizon.

Guidelines for a 409A Valuation

The IRS has stipulated several guidelines for 409A valuations. For instance, it recommends that the valuation be conducted by a third party certified by the American Institute of Certified Public Accountants.

By doing so, the onus of the proof that the valuations are accurate lies on the IRS. On the other hand, if a company does it in-house, this comes with significant risk. In this scenario, there is a potential for hefty penalties to be levied by the IRS if the valuations are deemed to be inflated in the future.

The 409A valuation report is valid for up to 12 months from the valuation date. If stock options are not offered within this time, a consecutive 409A valuation will need to be commissioned  later before the company issues stock options.

Key Documentation and Information Requirements 

The independent third-party appraiser will ask the company to hand over several documents. This enables them to thoroughly examine the company’s assets, liabilities, revenues, profits, and other key metrics.

Basic documents include articles of incorporation, an updated capitalization table, a company pitch deck, all financials, including profit and loss statements and bank statements, and shares purchase agreements.

Since stock options serve as a significant hiring carrot, the company may be asked to share an estimate of how many stock options they aim to offer over the next 12 months, based on their recruitment plans.

If the company has already done a 409A valuation earlier, it will need to update the third-party appraiser of any key events that might have occurred since then. For instance, this could include new investors, mergers and acquisitions, new divisions, and shutting down old businesses. They will also need to share if they plan to be acquired in the next few months or if any other significant plans may be in the pipeline.

If the company aims to go public, it will need to share a time frame.

Determining 409A Valuations 

Appraisers use various benchmarks to determine a startup’s 409A valuation. For instance, if the company is an early-stage startup, they will reference comparable publicly-traded businesses, and look at their stock price, profits, revenues, and EBITDA. Appraisers also consider the cost of preferred stock held by investors with the power to exert control through their stock holdings. Once the appraiser determines the 409A valuation, the startup’s board will vote to approve the valuation before issuing stock options. There is a possibility that the valuation does not match the company’s expectations. In this scenario, the company can review the reasons for the valuation and work towards improving the company’s performance on various factors. It is preferable to go with a realistic valuation rather than face the music later, during a crisis triggered by inflated valuations.

The Takeaway 

Choosing a credible third-party appraiser is important in getting a sound 409A valuation. Companies can review the types of businesses they have done valuations for earlier and make an informed decision when choosing their 409A valuation partner.

trica is a state-of-the-art stock options management tool leveraged by startups to build a superior experience when issuing stock options programs. This end-to-end solution is an excellent investment for businesses looking to hire and retain the best talent, with stock options as an offering.

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