What Is a 409a Valuation?

Definition & Examples of 409a Valuations

Young employees socializing at work

 Thomas Barwick / Getty Images

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

What Is a 409a Valuation?

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. This 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.

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.

409a valuations should be made every 12 months or at every round of funding. 

How 409a Valuations Work

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. 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 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 then sell the stock at $30 per share and make a nice 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.

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.

How to Determine a 409a Valuation

Software programs exist to help you determine fair market value yourself, and this 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.  

Is a 409a Valuation Necessary?

Let’s say your startup company is eager to issue stock options to employees and skips the process of a 409a valuation by just guessing what a reasonable share price would be.

If you are audited by the IRS, you could find yourself in a world of hurt. First, the employee would immediately be taxed at the ordinary income rate for all vested options, plus a 20% penalty. There may 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 adviser.