What Founders Need to Know About 409a Valuations
TL;DR: 409a valuations are essential for startups because they protect the tax benefits of being an early employee or founder. By establishing the fair market value of your company’s common stock, you ensure the strike price is defensible and that it will hold up to IRS scrutiny.
Without 409a valuations (often recommended by tax professionals to do every 12 months or after a material event), the IRS can challenge the valuation down the line, creating penalties for both your company and employees.
What is a 409a Valuation?
A 409a valuation is an independent review of the fair market value (FMV) of a company’s stock. The results will determine the minimum strike price of a company’s stock, or the price that employees will pay to purchase their shares.
Getting 409a valuations ensure that companies are providing reasonable or appropriately valued prices for equity-based compensation and without it, companies and their employees are at risk of significant tax penalties.
A 409a valuation is not equivalent to the valuation a startup raised at. A startup might have a valuation of $10 or $20 million based on their latest raise, but for a variety of reasons (such as the fact that the stock is not easily able to be sold), the 409a valuation will be much lower. Definitionally, there will be a pretty large delta between the stock price implied by your raise, and the stock price set by the 409a.
Why startups need a 409A valuation
As a startup, one of the most powerful tools you can use to attract talent at your company is equity. Before issuing option grants, it's essential that companies get a 409a valuation because it protects both you and your employees from IRS penalties. These penalties can include immediate taxation, federal penalty taxation, and potential state penalties.
There’s also an art to getting 409a valuations right. Some founders simply believe the lower the strike price the better (as it makes options cheaper for them and their employees to exercise). However, it is crucial that your company’s strike price is backed by material facts about the business (e.i. revenue or runway). This makes your valuation defensible so that down the line, if you have a liquidity event or the equity is worth something, it can hold up to IRS scrutiny. Ultimately, your valuation is not just about getting the lowest number possible, it’s about setting a justified strike price and protecting your company and employees.
When should you get a 409A valuation?
Get your first 409a valuation:
Before offering your first stock options to employees or advisors
After your first 409a, get refreshed:
Once every 12 months (experts generally recommend annual refreshes)
After a material event that could impact the value of your company (e.g. closing a new financing round, hitting or missing milestones, major changes to financial projections)
How do I get a 409a?
Find the right provider. A provider should be a firm that can provide an accurate and defensible valuation. Your cap table provider can refer you (Carta, Pulley, GlobalShares) to one of their partners, or you can go to an audit firm directly yourself.
Build a data room. 409a valuations often require companies to provide key documents such as articles of incorporation, cap table, and financial statements or projections
Review draft report. Your provider will draft a 409a valuation report. Review the draft for accuracy.
Bottom Line
409a valuations are not options, especially for startups where equity-based compensation can be leveraged to attract talent and strengthen your team. Not only is it a compliance necessity, but it can demonstrate organizational maturity to investors and ensure your company is prepared to raise. With the right providers, the process is simple: gather documents, meet with a valuation analyst, and review the 409a valuation report.
