Do we need a 409A valuation even though we just had a financing with a set valuation?

Takeaway: Yes, you need a new 409A valuation every time something happens that materially impacts the value of the company’s stock. Receiving a term sheet for a preferred stock financing typically ascribes a valuation to the company, which imputes a price to the stock and invalidates your 409A valuation. You’ll need to wait until after the financing is complete to get a new 409A and begin issuing options again at the new exercise price.

The short answer is yes, you will need to get a new 409A valuation. Preferred stock financings involve investors and the company setting a valuation for the company. As a consequence, the company’s stock typically becomes too expensive for employees to purchase, which becomes an issue for equity compensation. The way to solve this is to begin issuing employees and other service providers stock options (i.e., options to purchase shares of stock) instead of shares of stock.

For startups, the exercise price of the stock options that it issues to its employees and other service providers should be at least equal to the fair market value of its shares. Since a preferred stock financing changes, the fair market value of the shares, startups need to obtain a 409A valuation after a preferred stock financing to ensure that the fair market value of their stock options is accurately reflected in the exercise price of those options.

Impact on employees

The exercise price of stock options can have a significant impact on the employees who hold those options. All things equal, employees prefer a lower exercise price on their stock options because it means they have to pay less for each share when they exercise the option. In most cases, a preferred stock financing will increase the exercise price of the stock options the company subsequently issues. So, it is important to ensure that you issue any promised stock options well in advance of your preferred stock financing. There is no bright line rule, but many practitioners consider receipt of a signed term sheet as an event that invalidates your existing 409A valuation.

Conclusion

Obtaining a 409A valuation after a preferred stock financing is an important step for startups to take to ensure that their stock options are priced in compliance with tax regulations and provide a valuable incentive for employees to contribute to the company's success. If you are a startup considering a preferred stock financing, it's important to work with a qualified attorney and tax professional to ensure that the exercise price of your stock options is set at a fair market value to avoid penalties for both the company and the option recipient.