If you’re a founder trying to figure out how to set the price your employees should pay for shares of your company's common stock, you’ll need a 409A valuation.
A 409A valuation is an assessment of the fair market value of a private company’s common stock, done by independent appraiser. The 409A is important because it determines the strike price, which is a set price at which a stock can be bought or sold. This is the price at which you can provide stock options to your employees.
It’s essential to ensure you’re getting an objectively accurate valuation because the strike price you land on has implications, particularly related to stock options, taxes and audits.
How a 409A valuation works
The 409A valuation process typically has three steps: (1) the assessor figures out how much your company is worth, also known as its enterprise value; (2) they then figure out the fair market value (FMV) of your company’s common stock by allocating the enterprise value across equity classes; and (3) they lower the price of the FMV to account for the fact that the stock is not publicly traded.
The IRS rules associated with the 409A valuation are laid out in U.S. Code § 409A. Public companies don’t have to worry about Section 409A because any stock options they offer employees will have a strike price equal to their stock’s FMV. But these rules can be more problematic for privately-held companies, like startups, since the strike price and the FMV are likely different.
How the strike price affects employees
IRS rules in Section 409A stipulate that if the strike price of a stock option is a fair market value on the date of issuance, then the stock option is treated as non-qualified deferred compensation—that is, compensation that an employee has earned but that they have not yet actually gotten from their employer. Under IRS rules, employees don’t have to pay taxes on deferred compensation until they actually receive the funds, and employers don’t have to worry about withholding on deferred payments.
Section 409A puts strict regulations on how to ensure that stock options count as deferred compensation. If the 409A rules are not followed exactly, employees can find their options deemed taxable compensation instead of deferred compensation, leading to surprisingly large income tax bills they weren’t expecting.
Importantly, if the strike price is set too low for the IRS to agree that it reflects fair market value, then the agency may deem employees’ options to be taxable. This would give the employees tax obligations and the employer withholding obligations.
How stock options are taxed
Stock options can be treated as either qualified stock options (QSO) or non-qualified tax options (NQSO) for tax purposes. Another name for qualified stock options is Incentive Stock Options, or ISO. The difference between these types of options is that profits made from QSO are taxed at the capital gain tax rate, which is typically below the option owners’ income tax rates. Gains from NQSOs, on the other hand, are taxed as income, which means they are usually taxed at a higher rate than QSOs.
The advantage of NQSOs, despite the higher tax rates applied to them, is that they provide more flexibility regarding who can receive them and how they can be exercised. A recipient of NQSOs can immediately sell them, pocketing the difference between the market price of the option and the grant price—that is, the fair market value of the stock on the day it was granted. Meanwhile, a recipient of QSOs must hold them for at least one year before selling them. Companies, for their part, tend to like NQSOs better because the cost they incur for NQSOs can be deducted as an operating expense quicker than the cost of NSOs.
Why to avoid in-house valuations
The need to avoid unexpected taxation is why it’s vital to get an objective and accurate estimation of the stock value under 409A. To help privately held companies cope with the difficulties of 409A, the IRS allows them to determine the FMV of their common shares in a way that the agency will accept, known as “safe harbor.”
Getting an accurate and objective judgment from a third party on your company’s valuation is the best way to ensure 409A safe harbor. Startups typically pay for these assessments, and there is now an entire industry of 409A valuation, with many firms offering these services. The cost of paying for a valuation by an outside firm is worthwhile, as it ensures that your company’s valuation will meet safe harbor standards and will withstand the scrutiny of an audit.
By contrast, quick valuations and those done in-house are high-risk and usually not defensible in an audit. The reason that the IRS is skeptical of in-house valuations is that there were cases of abuse in the past in which Boards artificially lowered the strike price to create attractive options to entice employees. The 409A rules were in part an effort to curtail such manipulations, so companies that continue to determine their own stock prices will receive much scrutiny and intense skepticism from the taxing agency.
For this reason, LTSE Equity provides third-party 409A valuations that are defensible to ensure the success of future audits.