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 are critical to a company’s long term success, but they’re far from the sexiest part of being a founder.
Getting a proper 409A valuation is a problem you will need to solve. This post will explain the 409A process and give you an idea of what to expect.
409A valuations determine the fair market value of common stock
First, it is important to distinguish between a 409A 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 set by a 3rd party valuation service. 409As are regulated by the IRS (you can read more here). They set the exercise price for options issued to employees, contractors, advisors, and anyone else who gets common stock. To maintain safe harbor, 409A valuations are required annually or each time the company has a material event, like a new financing.
A 409A valuation is often (but not always) different from a company’s post-money valuation after fundraising. Investors get preferred stock, which is usually more valuable than common stock, due to the rights and preferences typically afforded to preferred stock.
While it’s possible to run your own financial analysis to determine your FMV very early on in your company’s lifecycle, valuations are difficult and take a lot of time. Third-party, independent valuation providers establish safe harbor status. Safe harbor protects against penalties for common shareholders if the IRS determines a company’s FMV was set inaccurately.
Safe harbor means you’re protected from certain IRS penalties
Safe harbor means that your company has completed an acceptable 409A valuation in the last twelve months. This means you don’t have to prove to the IRS that your FMV is accurate during that period. Usually 409A valuations are performed by a third-party. In some rare cases, it’s possible to gain safe harbor if an internal employee with adequate accounting experience performs the valuation, but we rarely, if ever, see companies choose this option.
If you don’t have safe harbor and an IRS audit determines your option grants were not issued at fair market value, employees would be impacted.
Here’s what would happen to the employees who received incorrectly priced options:
- They would be taxed on those options immediately
- They would be fined an additional 20% of the value of their option grants and will likely have to pay other penalties as well
It would be a significant financial burden to employees who should have been protected by a more knowledgeable and responsible founder.
You’ll need a new 409A every year or each time you have a material event
As a startup founder, in general you’ll need a new 409A valuation every year or each time you have a material event, like a new round of financing. Here are some guidelines to follow on 409A timing:
- Generally, you should get your first valuation before you issue your first common stock options (typically to your first hire or advisor)
- You should get a new 409A 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 twelve months, or when materially necessary, to maintain safe harbor. A material event is an event that could reasonably be expected to affect a company’s stock price.
Avoid 409A penalties
409A valuations help protect your company from costly audits and your employees from significant penalties. Carta can help ensure your company maintains safe harbor.
Reach out to our team today, or watch our team discuss avoiding common 409A pitfalls in our webinar below.