Once your startup goes public, any and everyone can see what you’re worth. But when you’re private, you still want to have a way to know where you’re valued. Fortunately, you don’t have to fly blindly here. You can get a 409A valuation.
This valuation, which you generally want to have performed by an independent firm, measures the fair market value (FMV) of your common stock. That means it’s essential if you want to offer shares to employees. And once you do grant shares, it becomes even more important for tax purposes.
How a 409A valuation works
To start, it’s helpful to understand the foundation. These valuations get their name from Section 409A of the Internal Revenue Code (IRC). This part of the IRC talks about compensation that workers earn in one year but don’t necessarily get paid in that year (what the IRS calls “nonqualified deferred compensation”). That means it applies to stock options that you grant to employees.
Because the IRS sees any shares you issue to employees as part of their compensation, it needs a way to monitor and — you guessed it — tax them. But if those shares are issued at some nebulous price, that’s all but impossible.
Enter: 409A valuations. When they’re performed by an independent third party (like a firm that offers 409A valuation services), it legitimizes that share price in the eyes of the IRS. And that can have some serious benefits; namely, avoiding hefty taxes and penalties.
There are a few main things you should know here:
- In the vast majority of cases, the 409A values your common shares, not your preferred shares.
- When performed by an independent firm, your 409A valuation provides safe harbor tax status for those shares.
- 409A valuations are valid for 12 months unless a material event occurs that would change the price of your shares (like a new round of funding).
- 409A valuations usually price shares lower than recent funding round valuations, partially because funding rounds focus on the value of preferred stock rather than common stock.
Ultimately, a lot goes into a 409A valuation but an experienced firm can handle it for you. The main thing to know is that this can be a useful tool for your startup, and it might be necessary to comply with the IRC.
Why startups need 409As
It’s pretty darn hard to offer equity in your company without knowing what it’s worth. While you generally get funding round valuations when you’re trying to draw in new investors, you also need to know your startup’s valuation if you want to grant shares to employees.
In fact, it’s best practice to get a 409A valuation before you issue your first share of common stock.
The valuation gives you a solid leg to stand on to incentivize employees with shares. If you tell them, “We think our startup is worth this much,” that might not go very far. But having proof from a third party shows that you’re not the only one who believes in what your company is building.
When your startup is cash-strapped, giving employees equity in the company can go a long way. It can help you build more enticing compensation packages to attract top talent. More importantly, it can give you a way to retain valuable team members. As we head into what looks like a downturn, granting shares can give you a way to compensate staff even if cash flow gets tight.
409As and tax implications
Handling the valuation process properly can save your shareholders from some pretty significant tax penalties.
Specifically, if your startup gets audited but you have a valid 409A valuation, it creates a safe harbor. The IRS considers granted share prices “reasonable.” That’s important because if they don’t, any shareholders can be assessed penalties.
If you don’t get your valuation performed by an independent firm and simply price shares with your own internal knowledge, you’ll have issues during an audit. Your startup will be hard-pressed to prove that the price was reasonable and that you had the resources to determine your FMV. If you can’t do that, any shareholders could be subject to the serious penalties.
They could need to:
- Pay income taxes on those shares
- Pay accrued interest on the revised taxable amount
- Pay an understatement penalty of 20%
- Pay applicable state taxes on those shares
Suddenly, the shares you offered to cushion your employees become a heavy financial burden for them.
It’s also important to remember that your 409A valuation is good for 12 months or until a material event occurs that would change your share price. When in doubt, it’s probably a good idea to get revalued.
Why companies are revaluing right now
If you do decide to get a new valuation, you won’t be alone. As the market trends downward, more and more companies are getting revalued. While you might think a lower 409A would be a bad thing, it can actually be helpful. This gives them the means to drive inflated stock prices down so they can offer shares to employees at a lower price. In short, a lower 409A can be a useful recruiting and retention tool.
Getting an accurate 409A
As we mentioned before, the best way to establish a safe harbor for your employee shareholders is to have an independent firm perform your valuation. Fortunately, many companies offer this service.
Even more good news: we can help. Our team at ShayCPA can project manage your 409A experience. Since a big driver of the valuation is your historical financial documentation, we can be there to provide what the valuation firm needs. This doesn’t just keep work off your desk. It also ensures that the firm has all of the most updated documentation in the best format, giving you the most accurate valuation possible.
Whenever one of our clients enters into a 409A valuation, we walk side by side with them. Our team stays involved and responsive to answer questions, provide necessary details, and make the process as streamlined as possible for you.
If you want to learn more about 409A valuations in general or how we can help, contact us.