If your company grants stock, you may have heard of the importance a 409A valuation. Here, we’ll take a look at the purpose of a 409A valuation, and why you might need one.
409A Valuation Defined
Say your company issues stock options for employees—the rights for individuals to buy stock at a fixed price for a certain time period in the future. Said options will include the fair market value of the stock and the strike price at which an employee can buy the stock. Generally, it’s going to be important for the strike price to be set at or above the fair market value of the stock.
If the strike price is set below the fair market value of the stock, there are going to be consequences. First, the employee will be taxed on the difference between the strike price and the fair market value. Further, the employee will be hit with an additional 20% tax on the difference between the strike price and the fair market value. Certain states also have their own penalties and taxes that may apply.
In short, companies want to avoid being called out for having a strike price lower than the fair market value. In comes the 409A valuation. The 409A valuation gets its name from Internal Revenue Code section 409A, which outlines nonqualified deferred compensation and some of the penalties outlined above. If a company performs a 409A valuation to determine the fair market value and the strike price, such valuation can be presumed reasonable and will shift the burden from the company to the IRS to show that the fair market value is unjustified.
409A Valuation Deadlines
There are generally two times when you should do a 409A valuation. Your 409A valuation is good for a period of 12 months, so every year you’ll need to do a new valuation to stay compliant. The other time, and exception to the previous rule, is when your company has an event that materially affects the fair market value of the company and its stock. A common example includes bringing in significant outside funding.
There are two common ways to go about your 409A valuation. The first, and most expensive option, is to have the valuation done by a qualified independent appraiser. The second option is to have the valuation done by someone, usually a company employee, with “significant experience”. Meaning, said person should have at least five years of experience with business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or similar experience in your industry. Do be aware though that there are additional requirements that must be met to go with the latter route.