When Should You Get a 409A Valuation for Your Stock Options?

Following the 2001 Enron accounting disaster, the government mandated that companies value stock options fairly before issuing them to employees. The 409A valuation of the tax code requires startups to conduct regular third-party audits to determine the value of the common shares before granting employee stock options.

For a private company, the only way to offer employee options on a tax-free basis is through a 409A valuation.

According to the IRS, a 409A valuation is only valid when performed by an independent, third-party entity. The valuation should not be taken lightly. The IRS may impose fines when a startup violates 409A regulations and mispriced equity. Ultimately, shareholders and employees bear the brunt of these violations.

What Is a 409A Valuation and Why Does a Startup Need It?

A 409A valuation assesses the fair market value (FMV) of a startup’s common stock. This valuation will ascertain the strike price for a startup’s stock. This is usually carried out by a third-party firm specializing in valuations, and it takes place in the wake of significant occasions like new funding.

A startup planning to give stock options must complete the 409A valuation and adhere to all tax regulations. This avoids any IRS audits that can result in legal hurdles, tax problems, or even interfere with the company’s operations.

When Should A Startup Get a 409A Valuation Done?

In general, a 409a valuation is required in three scenarios:

1. When the Startup Plans Stock Options

Many startups offer stock options to attract and retain talent. However, if the startup gives the new hire a stock option valued lower than what the IRS considers appropriate, the startup will run into trouble. In such a case, the IRS imposes a 20% penalty on the valuation to compensate for the difference in strike price and the fair market value.

Therefore, getting a 409A valuation before offering stock options would be wise.

2. When the Startup Has a Material Event

Anything that impacts the startup’s valuation is considered a material event. It may consist of the following:

A funding round

When a firm raises its initial round of funding, it typically completes its first 409A. Refreshing the 409A valuation after each succeeding round of capital raising is a great practice. Early-stage companies can offer stock options at the strike price established under its 409A valuation. The only exception to this rule is when one of these companies has a value inflection moment, such as new financing, which necessitates a fresh valuation.

Exit and Acquisition/Mergers

Later-stage businesses should have a broader discussion with their auditors and legal counsel to determine the best frequency, possibly switching from an annual cadence to a semi-annual or quarterly one, in anticipation of some kind of exit. A company’s cadence typically increases noticeably every quarter as it prepares for a prospective IPO in the next 12 to 18 months.

3. Major Events

Another exception is global events like pandemics. COVID-19 was completely unanticipated and substantially impacted many businesses, affecting their valuations. Large, unanticipated market movements like this necessitate at least a second discussion about whether it is only a passing blip that has changed the valuation. Can you expect that valuation to stabilize in the next 6 to 12 months, or should you hold off on the next valuation?

Documentation Required for a 409A Valuation

Once a startup has scheduled a 409A valuation, it must share the following information with the third-party valuation firm.

Company Details

1. CEO’s Name
2. Name of the legal counsel
3. Name of the external audit firm
4. Amended Articles of incorporation

Industry Information

1. Category of the industry
2. A list of comparable public companies

Fundraising

1. The expected date of a liquidity event
2. The number of options the startup plans to issue over the next twelve months
3. Company presentation, business plan, and executive summary

Company Financials

1. The financial statements
2. Revenue projections for the following year
3. Earnings before interest, tax, depreciation, and amortization (EBITDA) projections for the upcoming year
4. Cash runway and burns
5. Non-convertible debt count

Determining the 409A Valuation

An appraiser will typically use a “market” 409A valuation method to ascertain the fair market value of a company’s common stock for early-stage businesses, andconsider the price of the company’s preferred shares. Accordingly, they will examine the financial data from a group of comparable publicly traded companies, such as the revenue, stock price, and EBITDA.

Investors are given shares of these companies that allow them particular privileges and rights to control the company’s direction to some extent.

Then, to account for the illiquidity of the shares, the appraiser applies a discount to the company’s common stock (which makes it less valuable than the stock that can be readily sold). The discount rate changes depending on how close to a liquidity event the company is.

The Bottom Line

Most startups are not likely to be audited by the IRS. However, suppose the startup plans to offer stock options to employees or moves closer to an exit (such as a merger, acquisition, or IPO), it will probably be subject to IRS audits and need a 409A valuation.

The 409A valuation cannot be completed successfully with a rudimentary understanding of accounting. Hence, you need qualified, well-experienced, efficient, and ethical experts who know what they are talking about. Working with a reliable valuation service provider will save the time and resources of the startup.

trica equity partners with Aranca to deliver quick yet comprehensive 409A valuation services in the US. Our valuations come with a safe harbor and consider all the macroeconomic, industry-related, and firm-specific factors for arriving at an accurate value.

We go one step beyond compliance with IRS norms and act as an informative tool for auditors and investors.

Get in touch with us today for a free 409A valuation demo!