409A Valuation: The Impact on Employee Equity

Learn about the importance of a 409A valuation when offering US-based employees stock options.

A 409A valuation is a crucial step for startups offering equity compensation to US-based employees. It ensures compliance with the IRS. If you have employee equity compensation or planning to begin doing so, you must get a 409A valuation. Learn what precisely a 409A valuation is and its impact on employee equity.

What is 409A Valuation?

A 409A valuation is a process of establishing a fair market value (FMV) of your company’s common shares performed by a third-party valuation provider. The valuation determines how much taxes employees will have to pay when exercising or selling their stock options. The valuation is regulated by the Internal Revenue Service (IRS). 

The purpose of a 409A valuation is to estimate the fair market value of your company’s common stock. It is especially relevant in the context of employee equity. You are legally obligated to provide a fair price at which employees can purchase the common stock. Failing to price your shares reasonably may make your startup and your employees liable for a potential underpayment of taxes, resulting in IRS fines and audits. 

Is a 409A Valuation Required?

You must get a 409A valuation every 12 months when offering equity compensation. But you may be required to do it more often. For example, when a material event like fundraising happens, your valuation will be affected. In that case, you have to get another valuation whenever you raise money. Startup founders must not forget to do a 409A valuation whenever raising funds and having equity compensation. So, if you are offering stock options to US-based employees and want to stay compliant, you must get the 409A valuation of your stock. 

Note that international companies may be subject to other laws. But if you have US-based employees, you still may consider obtaining a 409A valuation to stay compliant with IRS regulations. Due to the complexity of the subject, we recommend seeking professional advice with legal counsel from a tax consultant. Also, make sure to check out the guide to startup valuations

What happens when a startup fails to do a 409A valuation?

When a startup fails to obtain a 409A valuation, it may be subject to hefty fines and penalties imposed by the IRS. Here is why: a 409A valuation determines the fair market value (FMV) of shares. When offering stock options to their employees, the exercise price (strike price) is used with the FMV to determine the taxable income in case the employee exercises and sells the shares. Skipping the process of getting an FMV for your shares may lead to company audits and be viewed as tax avoidance. 

Startups may also expose owners of stock options to unnecessary dilution. Such a situation may harm the team morale as dilution will negatively impact employee compensation. With any event that changes the company's valuation, stock options will also be affected. And as a result, their owners will be too. It is highly recommended that startups get a 409A valuation to remain compliant with tax laws and protect their stock options from dilution. If you want to dive deeper into the topic of taxation and 409A non-compliance, check out this guide.

4 things to know about 409A valuations

409A Valuation vs Venture Valuation

409A valuation vs Venture Valuation comparison table

Venture valuations (pre/post-money valuations) and 409A valuations serve different purposes. Venture valuations provide more clarity during the fundraising process. Venture valuations, also known as pre/post-money valuations, are done by investors. When fundraising, these become benchmarks for a startup valuation to guide negotiations between investors and founders. 

409A valuations are different. While 409A valuation is a mandatory element when offering equity compensations. First, third-party valuation companies perform these. Typically, 409A valuations appear to be smaller than the ones done by venture investors. But it’s important to note that when offering employee stock options, you must get this type of valuation to stay compliant. Nevertheless, keeping your valuation up-to-date is critical for maintaining a reliable cap table for your startup.

How Much Does a 409A Valuation Cost?

Since you want to obtain a legally required 409A valuation from a third-party valuation company, you will have to pay. The fee for the valuation service changes depending on several characteristics. For example, the stage your company is at, the size, and the complexity of your case. You can expect to pay a ballpark fee between $1,000 to $10,000 per valuation. But it can still go higher. 

The expected price of a 409A valuation is between $1000 and $10000.

There are other ways to get a much cheaper valuation of your company's stock. For example, you can do it yourself or use a particular software to get a valuation. But, as a note of caution, it is crucial to know that these are risky options that will not guarantee compliance with the IRS. Depending on your situation and stage, the need for valuation and the corresponding demands may differ. Therefore, we recommend talking to an expert to find a solution that fits your particular case. 

What Is Required to Complete a 409A Valuation?

Here is the key information required to perform a 409A valuation: 

  • Capitalization table of the company (including the data on shareholders, vesting, stock option pools, and other)
  • Certificate of incorporation
  • Historical and forecast financial statements and the company’s financial performance, along with the business plan (if available)
  • An overview of the company’s business model
  • The company’s intellectual property, products and services, and customer base
  • An overview of the company’s organizational structure 
  • An explanation of compensation policies and structure
  • Information on recent transactions and stock purchase agreements with the term sheet (if any)

Depending on your stage and your case, there may be other requests for information you will have to provide.

The 409A valuation checklist with the information that can be required.

What Happens if the FMV Falls Below the Exercise Price?

When the FMV of the company’s stock is below the exercise price of stock options, the owners of stock options are at risk of being unable to convert their assets. In such a situation, the owners of stock options are said to own underwater stock options. 

A visual representation of the underwater stock options when FMV is lower than the exercise price of stock options.

One of the ways your company can protect employees with underwater stock options is to have a repricing policy. It will allow changing the exercise price to the current FMV. It lets employees potentially gain from the stock appreciation in the future. Of course, such a practice requires a close look from experts. It will guarantee that the policy is executed correctly and beneficially for all the parties involved while staying compliant. 

Also, you can use a different type of equity compensation to decrease the chances of such a situation happening. Restricted Stock Units (RSUs) are growing in popularity since they work differently. This type of equity compensation differs from stock options since, with RSUs, employees don’t have to buy the shares, and there is no exercising. Instead, the company gives these shares to them at no cost.

However, in the case of RSUs, employees may receive shares that fell in value compared to when the offer was made. But, if the value does increase, the employees will have to pay taxes on the difference between the current fair market value and the predetermined price (the offered value for the shares). 

Your Company’s 409A Valuation at Capboard

Capboard partners with specialized third-party valuation companies and allows you to get your 409A valuations easily. These can then be added to your cap table on Capboard, ensuring your data on the company’s stock value is trustworthy. Having an up-to-date valuation and keeping the stakeholders in the loop is crucial. It helps to build trust and ensures transparency within your company.

Every startup valuation update has an impact on all of your company’s shareholders. Thus, it’s critical to provide them and yourself with much-needed visibility and clarity around equity ownership.

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