A start-up 409A valuation is a framework that allows private companies to correctly value private stock options at the time of grant. This protects the employee from receiving options that are not worth the fair market value.
When a business is first starting up, cash flow is often limited. This can make it difficult to pay employees their full salary, as much of the budget may be allocated to other areas. However, if a company wants to utilise the best talent, it may provide a future incentive in the form of equity rather than an immediate payment. This could entice employees to work for less money up front, with the understanding that they would own part of the company in the future.
Why Are 409A Valuations Required for Start-ups?
A 409A valuation is required for private companies to offer equity to employees without being subject to taxation. The value of a private company's common stock isn't readily available because it's not listed on a public stock exchange, so a 409A valuation start-up is necessary to determine the value.
The IRS has issued regulations that require companies to use a "reasonable method" of determining the fair market value (FMV) of their stock at the time of grant. One way to ensure that the value of the stock is presumed to be "reasonable" by the IRS is to use an independent third party to determine the FMV of the company's common stock every 12 months. What the IRS refers to as a "safe harbour" for the corporation is established by a fair valuation methodology.
By using an independent third party to determine the FMV of its common stock every year, companies can avoid any potential issues with the IRS regarding the value of their stock. This yearly valuation will create a safe harbour for companies, giving them peace of mind that their stock is valued correctly.
If the company doesn't have a 409A valuation start up safe harbour, it could be subject to a major tax penalty. If the IRS decides that the company's valuation is unreasonable, all deferred compensation for employees from the current and previous years could become taxable immediately, with an extra 20% tax penalty.
When must a 409A value report be obtained by start-ups?
Startups will often get a 409A valuation startup value after they've raised money from investors and issued preferred stock. "Material events" that can trigger the need for your startup to get a 409A valuation report include:
- 1. A qualified financing event is the sale of common shares, preferred stock, or convertible debt to outside investors. This usually happens when a company is first starting and needs initial funding, such as during a series A round.
- 2. Other material events that can affect a company's finances include mergers, acquisitions, secondary sales of common stock, business model pivots, and major changes to financial projections.
Internal Revenue Code 409A valuation startup is only valid for a maximum period of 12 months. If something changes within your company (we call this a “material event”) before the 12 months are up, your company will need to get a new 409A valuation date. When a start-up grants common stock options, it will give employees an exercise price based on the most recent 409a valuation report prepared for the company.
Do I need a 409a valuation and what is a safe harbour?
According to 409A valuation start up regulations, companies have the option to obtain a “safe harbour” valuation. A safe harbour valuation is presumed to be correct because it was done through the proper framework. This implies that if the IRS subsequently declares, "We think that valuation was incorrect. The IRS now has the burden of demonstrating that the value was incorrect because your stockholders are generating too much money. Achieving safe harbour shifts the burden of proof to the IRS that the determined value was grossly unreasonable.
Finding a safe harbour valuation: 3 methods
There are three ways to get a "safe harbour" valuation under 409A regulations:
- 1. Independent evaluation technique: The fast 409A valuation is done through a proper framework and is therefore presumed to be correct. This means that if the IRS later says the valuation is inaccurate, they have to prove it. This is usually the safest and most popular option, as it provides credibility and assurances from an independent specialist.
- 2. Evaluation using the formula: This method is available to a few companies that meet specific conditions. For example, the stock must have non-lapse restrictions and the formula must be used in all transactions where the issuer buys or sells the common stock. An impartial third party does the appraisal.
- 3. Illiquid start-up technique: The 409A valuation start up is based on recent transactions involving identical or similar companies. A safe harbour valuation is an appraisal of an asset, typically done by a qualified person, that can be used to establish the value of the said asset for tax purposes. The term "safe harbour" comes from the fact that the IRS has established specific standards that appraisers must meet for the valuation to be considered valid. As long as the appraiser meets these standards and provides a written report detailing their findings, the 409A valuation date can be used to determine the worth of an illiquid start up for tax purposes. The value of the start-up is determined by taking into account factors such as the market value of similar entities, the value of tangible and intangible assets, control premiums, etc.
If you want to qualify for safe harbour status and avoid IRS penalties, it's important to have proper valuation and governance processes in place for your stock options. Hiring an independent appraiser to perform a 409A valuation is the easiest and safest way to establish a safe harbour and protect your employees.
Your fast 409A valuation is a direct representation of both the company you're building and the shareholder wealth you're creating. It's important to work with your 409A provider to optimise your valuation but avoid using questionable valuation methods or making assumptions that could have negative consequences.