What is a 409a Valuation, and Should Your Company Have One?
Don't skip this step before issuing stock options to your workers.
We’ve all heard stories about employees of start-ups getting rich off of stock options.
Many new companies will offer shares of stock to their workers as an incentive, and it’s a great way for employees to feel truly invested in their work. Stock options can also be a good way for early-stage companies to compensate workers when they can’t afford to pay them more right away.
But if you are the owner of the company, there are some key steps you need to take before offering shares to employees. Perhaps the most crucial move is to obtain something called a 409a valuation.
In simple terms, a 409a valuation is an appraisal of a company’s stock. Private companies that want to issue shares to their workers must be appraised because unlike public companies, there are no share prices available to view at any time.
A failure to get a 409a valuation could get your company in trouble with the IRS and create headaches for your employees. Here are some key things to know so you can compensate your employees with stock options and remain in compliance.
409a Valuations and “Strike Prices”
To understand 409a valuations, it helps to understand how private companies reward employees with stock options. Here’s an example of how they work:
- Company A hires a new employee and offers him the option to buy 1,000 shares of stock at the current fair market value. Let’s say each share is worth $1 at this point in time. This price is known as the “strike price.
- Company A tells the employee he can “exercise” that option after five years of working at the company. This is known as the “vesting period.” The vesting period at companies can vary.
- Five years pass and shares are now worth $30 per share. The employee exercises his option to buy 1,000 shares at $1 each. In essence, he pays $1,000 for something worth 30 times that.
- The employee can then sell the stock at $30 per share and make a nice profit.
A 409a valuation is necessary in this situation to determine the option price being offered to employees. The IRS does not want companies to simply make up a valuation. While employees surely would like to buy shares at the lowest price possible, if your company values itself too low, it could be accused of offering super cheap stock options as a way of hiding income.
Determining Fair Market Value
Section 409a of the tax code doesn’t specifically define “fair market value.” Other provisions of the code define it as the price at which the company would be bought and sold. Of course, that’s not easy to determine.
If you hire an outside firm to do an appraisal—which is the recommended way—that group can determine fair market value by examining the company’s financial statements. The firm may analyze the company’s cash flows, its assets, or both. It may also perform comparisons against companies of similar size in similar industries.
409a valuations should be made every 12 months, or at every round of funding.
Can You Do it Yourself?
There are software programs that can help you determine fair market value yourself, and this may save your company money. But, this is riskier than hiring an outside firm because you may not be eligible for something called “safe harbor.” If you obtain safe harbor, the IRS is required to accept your valuation unless it can prove it to be unreasonable. The burden of proof is placed on the IRS. Generally speaking, it’s hard to get safe harbor status unless the valuation is done by a qualified third party.
Hiring an outside firm to perform your 409a valuation will take roughly a month. Running the actual report may take a few weeks, and you must account for time to collect your necessary data up from and then make revisions later.
What Happens if You Don’t Have a 409a Valuation?
Let’s say you are a startup that is eager to issue stock options for employees and skip the process of a 409a valuation. You simply guess what you think is a reasonable price for shares.
You may be able to get away with this, but if you are audited by the IRS, you could find yourself in a world of hurt. First, the employee is immediately taxed at the ordinary income rate for all vested options, plus a 20 percent penalty. There may be additional state penalties, interest on unpaid taxes, and other charges. Imagine what happens to the company if it handed out stock options to dozens or even hundreds of employees in this way.
In short, obtaining a 409a valuation is an essential step for a company that’s ready to start compensating employees through stock options. You can move forward knowing that you are in compliance, and consider it a rite of passage as your firm grows.