What is a 409A valuation and do I need one?

Takeaway: Startups need 409A valuations to issue stock options. The IRS imposes some hefty penalties for issuing underpriced equity and getting a 409A valuation is a safe harbor from these penalties. They typically cost $2,000-3,000 and Carta includes one 409A valuation per year in their subscription plan.

409A valuations are a type of valuation used by startups to determine the fair market value of their stock for tax purposes. These valuations are named after Section 409A of the Internal Revenue Code, which governs the tax treatment of nonqualified deferred compensation plans. In this post, we’ll discuss some key features of 409A valuations and why startups need them.

Fair market value determination

A 409A valuation is used to determine the fair market value of a startup's stock options. This is important because the exercise price of stock options must be set at or above the fair market value of the underlying stock in order to avoid triggering negative tax consequences for both the company and the employees who hold the stock options.

Ongoing valuation

Assuming the company is issuing stock options, startups will need to obtain a 409A valuation at least once every 12 months, or more frequently if there are significant changes to the company's financial position or capital structure, including completing a preferred stock financing. This ongoing valuation requirement helps ensure that the exercise price of the company's stock options remains in compliance with tax regulations.

Qualified appraiser

409A valuations must be performed by a qualified appraiser with experience in valuing early-stage companies. This helps ensure that the valuation is performed accurately and in compliance with tax regulations. My preferred 409A valuation firm is Teknos Associates - contact Jim Timmins (jtimmins@teknosassociates.com and (650) 330-8800). Note that if your company is a Carta customer, their plans often include one 409A valuation per year so that can also be a good option.

Conclusion

409A valuations are a critical tool for startups to use to comply with tax regulations and avoid negative tax consequences related to their stock options. By obtaining regular valuations from a qualified appraiser, startups can 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.