What is a 409A valuation?
A 409A valuation is an assessment of the fair market value of a private company’s common stock by a third-party, independent appraiser. The assessment findings are communicated as a written valuation report to the company’s board of directors, which uses it to determine and set the price at which people may purchase shares of the company’s common stock.
What is a Section 409A valuation?
The name of this valuation comes from Section 409A of the U.S. Internal Revenue Code (the “tax code”). Section 409A was enacted in response to alleged abuses of deferred compensation arrangements revealed in several high-profile corporate scandals.
Among other things, Section 409A requires that options granted as compensation to service providers (employees or non-employees) have an exercise price, also known as strike price, equal to or greater than the fair market value of the shares underlying the options on the date the options are granted.
If an audit reveals that options were granted with an exercise price below fair market value, then the service provider who received the underpriced options may be subject to tax penalties.
What is 409A safe harbor?
By adhering to specific guidelines, your 409A can be considered "safe harbor" by the IRS (Internal Revenue Service), providing reassurance as the IRS presumes it to be valid unless proven to be grossly unreasonable.
IRC 409A offers three methods, known as presumptions, through which you can attain a safe harbor valuation:
- Binding Formula Presumption
- Illiquid Startup Presumption
- Independent Appraisal Presumption
The independent appraisal presumption, in which a qualified independent appraiser or third-party valuation firm performs the 409a valuation, is the most preferred way to get safe harbor status due to their expertise and timeliness.
How do you ensure the valuation is valid?
Obtaining a 409A valuation from an independent appraiser is one of the “safe harbor” methods of determining fair market value detailed in the tax code. If a company does not use a safe harbor method to determine the value of its stock, then the valuation it arrives at has no presumption of validity, and in the event of an audit, the company has the burden of proving its valuation is reasonable. That may entail producing financial documentation from around the time of its option grants.
If, instead, a company uses a valuation safe harbor, then the valuation that it obtained is presumptively valid; the burden of proof then shifts to the Internal Revenue Service to show that the valuation is “grossly unreasonable,” which is widely considered to be a high threshold. 409A valuation reports are valid for one year following the valuation date, unless a material event affects the valuation of the company’s stock (e.g., venture financing).
Prices for independent 409A valuations can cost several thousand dollars per year, but options like LTSE Equity helps startups get a 409A valuation done quickly and efficiently. Doing it the right way helps avoid the consequences of making mispriced equity awards.
In addition, not choosing a 409A safe harbor to determine fair market value when making equity awards may cause increased deal friction when raising financing or at the time of an exit (i.e. an acquisition or an IPO) because compliance with Section 409A can be a point of legal and tax scrutiny.
How long does a 409A valuation take?
The length of time for a 409A valuation can vary depending on several factors, such as
- the company's complexity,
- the amount of information available,
- and the type of valuation method used.
Typically, a 409A valuation performed by an independent appraiser or valuation firm can take anywhere from a few weeks to several months. LTSE Equity, however, offer the fastest and easiest way to get a 409A valuation in the market by, streamlining the process, and providing a more efficient solution for startups.
LTSE Equity simplifies the 409A Valuation process and reinforces transparency as we have an estimated timing at each step.
The first step is setting up or updating your cap table, which can take anywhere from 30 minutes for recently founded companies to 1 week for larger, more complex companies with many stakeholders.
The next step is to complete a questionnaire, which typically takes between 30 minutes and half a day, to give a high-level understanding of your business and market to the valuation analyst.
Lastly, your dedicated valuation analyst will schedule a 30-minute kickoff call with you to go over and discuss the 409a report. You will have the opportunity to ask questions and make revisions to the report before it is finalized. A draft of the 409A report will be submitted within ten days.
LTSE Equity helps startups get a 409A valuation done right so they can grant stock options safely.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.