What Is a 409a Valuation?

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DEFINITION

A 409a valuation is an appraisal of a private company’s stock in preparation for issuing shares to workers.

Definition and Example of a 409a Valuation

Private companies that want to issue shares to their workers must be appraised. Unlike public companies, there are no share prices available to view at any time. This type of appraisal is called a 409a valuation.

Failure to get a 409a valuation could get your company in trouble with the Internal Revenue Service (IRS) and create headaches for your employees.

There are many reasons a company may want to offer shares of stock to employees. For example, many new companies will offer stock to their workers as an incentive. Owning part of the company helps employees feel truly invested in their work. Stock options can also be a good way for an early-stage company to compensate workers if it can’t afford to pay higher salaries right away.

No matter the reason, a company that wants to offer shares to employees must get a 409a valuation. This should be done every 12 months or at every round of funding. 

How a 409a Valuation Works

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 them the option to buy 1,000 shares of stock at the current fair market value. Suppose each share is worth $1 at this point in time. This price is known as the “strike" price.
  • Company A tells the employee they 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 their option to buy 1,000 shares at $1 each. In essence, they pay $1,000 for something worth 30 times that.
  • The employee can either keep the stock or sell it at $30 per share and make a profit.

A 409a valuation is necessary for 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.

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.

How to Get a 409a Valuation

The recommended way to do an appraisal is to hire an outside firm. That group can determine fair market value by examining the company’s financial statements. The firm may analyze the company’s cash flows, assets, or both. It may also perform comparisons against companies of similar size in similar industries.

Software programs exist to help you determine fair market value yourself, which may save your company money. But doing so 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 and any necessary revisions.  

Do I Need a 409a Valuation?

Suppose your startup company is eager to issue stock options to employees and skips the process of a 409a valuation. Instead, you just guess what a reasonable share price would be.

If you are audited by the IRS, you could find yourself in serious difficulties. Employees could immediately be taxed at the ordinary income rate for all vested options, plus a 20% understatement penalty. There might be additional state penalties, interest on unpaid taxes, and other charges.

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.

Key Takeaways

  • A 409a valuation is an appraisal of value for a private company's stock.
  • This valuation is recommended before issuing any stock to employees.
  • Failure to obtain a 409a valuation can result in penalties for both the company and the employee.
  • The best way to conduct a 409a valuation is with an outside advisor.

Article Sources

  1. Internal Revenue Service. "Internal Revenue Bulletin: 2007-19."

  2. Internal Revenue Service. "Avoiding Penalties and the Tax Gap," Page 2.