Private company clients frequently ask us about granting compensatory stock options to their founders, employees and other service providers, including board members, consultants and advisors. Options and other equity awards can be an effective tool to align the interests of employees and other service providers with the interests of stockholders and to provide incentives toward enterprise value growth. This article demystifies 409A valuations for private companies: what they are, why do you need them, and how do you get them?
What is Section 409A and how does it relate to stock options?
Section 409A of the Internal Revenue Code (Section 409A) imposes a 20% penalty tax (in addition to any ordinary income tax!) on nonqualified deferred compensation that fails to satisfy certain requirements. (California levies yet an additional 5% penalty tax.) An option that is granted to an employee or other service provider in connection the performance of services may be “deferred compensation” under Section 409A if certain requirements are not satisfied. Good news—an option is generally exempt from Section 409A (and is not treated as deferred compensation), if, among other requirements:
- the option is an option to purchase common stock of the service recipient (e.g., the employer or a parent or subsidiary of the employer); and
- the exercise price of the option is not less than the fair market value of the stock on the grant date.
What is a 409A valuation?
To be exempt from Section 409A, options must be granted with an exercise price per share that is not less than the per share fair market value on the grant date. This means that options can’t be granted “in-the-money” or at a discount. Under Section 409A, a non-publicly traded company must determine the fair market value of its stock by the reasonable application of a reasonable valuation method. A valuation method is only considered reasonable if it takes into consideration all available information that is material to the value of the company and its stock. The valuation of private company stock is highly subjective and often imprecise. Section 409A provides several safe harbor methods for valuation, including obtaining an independent appraisal of the stock (often referred to as a 409A valuation).
Why do you need a 409A valuation?
Use of a 409A valuation to determine the fair market value of private company stock creates a rebuttable presumption that the valuation is reasonable. For example, if the company’s board obtains a 409A valuation prior to granting options and uses that valuation to set the exercise price of the option, the option is presumed to have been granted with an exercise price that was not less than fair market value on the grant date. This presumption provides significant protection to the company and the service provider receiving the options since generally the taxpayer has the burden to prove that the valuation was reasonable—this can be hard to prove after the fact. (Hindsight is 20/20!) The IRS may rebut the presumption by showing (for example, in an audit) that either the valuation method or the application of the method was grossly unreasonable.
409A valuations are also used to calculate the taxes (if any) at the time the option is exercised by a service provider. This means that if a company has a “stale” 409A valuation (as described below), the company should generally not grant options and it should suspend the exercise of its options.
When do you need a new 409A valuation?
A 409A valuation is presumed reasonable if it is determined not more than 12 months before the relevant transaction to which the valuation is applied (for example, the grant date of a stock option). A 409A valuation is generally considered “stale” and does not provide safe-harbor protection if a material event occurs after the valuation date, as determined based on all of the facts and circumstances. The following events are commonly considered “material” and may cause a 409A valuation to become stale:
- Financing Rounds: After each financing round (including equity financings, convertible notes and SAFE issuances).
- Mergers and Acquisitions: Any merger, acquisition or other corporate transaction that may impact the company’s valuation.
- Material Changes in Business Model: Significant shifts in the business model that could impact the valuation of the company.
- New Product Launches: Introduction of new products or services that significantly affect the company’s financial outlook.
- Changes in Capital Structure: Alterations in the capital structure, such as stock splits, reverse stock splits or stock dividends.
- Market Conditions: Following periods of significant market volatility or economic changes.
- Key Personnel Changes: After significant changes in leadership or key personnel that could influence the company’s value.
- Regulatory Changes: Changes in regulations that may impact the company’s valuation.
- Significant Operational Milestones: Achievement of key operational milestones that materially affect the company’s value.
This list is non-exhaustive. Prior to granting options, we recommend that a private company obtain a new 409A valuation following the occurrence of any material event that is likely to impact the value of the company and its company’s stock.
How do you get a 409A valuation?
Private companies can obtain a 409A valuation by engaging a qualified, independent, third-party valuation firm with expertise in valuing private companies. There are many firms to choose from, but most early-stage companies may find that it is most efficient to utilize their third-party capitalization table software platform, which often provides 409A valuations as an add-on (or even free) service. As part of their valuation process, 409A valuation firms will request detailed data regarding the company, including historical financial statements, capitalization tables, details of any recent “material events” and financial projections. After reviewing these materials, the 409A valuation firm will provide a valuation report with their appraisal of the fair market value of one share of stock as of a specific date. This valuation report will detail the methodologies and assumptions underlying the appraised value, which should be closely reviewed and discussed with the valuation firm and legal counsel to ensure that the stated 409A valuation is accurate and comprehensive.
But don’t I want a high valuation?
Some founders are concerned when the 409A valuation comes in below what they expect a venture capital firm or other investor to pay for a share of preferred stock. The 409A valuation is a measure of the stock that underlies the company’s options, which is most commonly common stock. That is a different security with different economic privileges and protections than the preferred securities commonly purchased by venture capital firms in a venture deal. Therefore, while the concern is not unwarranted, 409A valuations are rarely tied to the way in which private investors price private companies.
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