Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.
Compliance and 409A valuations aren’t the most exciting parts of being a founder, but they’re critical to a company’s long-term success. Here, we’ll explain what a 409A valuation is, how often you’ll need to go through the process, and more. You can also download a sample 409A report to get a general idea of what a 409A looks like.
409A valuations determine the fair market value of common stock
First, it’s important to distinguish between a 409A valuation and a valuation set by investors during fundraising.
A 409A is used to determine the fair market value (FMV) of your company’s common stock and is typically determined by a third-party valuation provider. 409As set the strike price for options issued to employees, contractors, advisors, and anyone else who gets common stock.
A 409A valuation is often (but not always) different from a company’s post-money valuation, which is based on how much investors paid for their ownership stake during a fundraising. Investors get preferred stock, so a post-money valuation is based on the price of preferred shares, whereas a 409A is a valuation of your common stock. Preferred stock usually has certain attributes that make it more valuable than common stock.
409As, which refer to the Internal Revenue Code Section 409A, are regulated by the IRS. To take advantage of the IRS safe harbor (i.e. not be subject to certain IRS penalties), 409A valuations should be done annually or each time the company has a material event, like a new financing.
The 409A safe harbor may protect you from certain IRS penalties
While companies often run their own financial analysis to determine FMV very early on in the company’s lifecycle, with time, those valuations become more difficult, require more expertise, and take more time. Third-party, independent valuation providers like Carta can help make sure you have a 409A on file, which may protect common shareholders from certain IRS penalties.
To take advantage of IRS safe harbor in the context of 409A valuations, your company should have completed an acceptable 409A valuation in the last 12 months. If you haven’t, or if the IRS determines that your valuation is grossly unreasonable (and therefore your option grants were not issued at fair market value), option-holders could be impacted.
Here’s what could happen to the employees who received incorrectly priced options:
- They could be taxed on those options immediately.
- They could be fined an additional 20% of the value of their option grants and might have to pay other penalties as well.
You’ll need a new 409A every year or each time a material event occurs
Here’s a summary of events that might trigger a new 409A valuation:
- Generally, you should get your first valuation before you issue your first common stock options (typically to your first hire or advisor).
- You will also need a new valuation after raising a round of venture financing, as the previous 409A becomes obsolete once the new round is raised.
- After that, you should get a new valuation every 12 months and/or when there is a material event which may impact the value of the company, to continue to take advantage of 409A IRS safe harbor. A material event is an event that could reasonably be expected to affect a company’s stock price, like another financing round.
Carta can help you avoid 409A penalties
Third-party 409A valuations can help protect your company from costly audits and your employees from significant penalties. Download the sample below to see what you could find in a 409A report.
Download sample 409A report
Please keep in mind that this sample was prepared for informational purposes only. Our actual reports may vary in the language and methodology outlined in this report. Reach out to our team today if you have any questions or need a 409A valuation.
DISCLOSURE: This communication is on behalf of Carta Valuations, LLC (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
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