Learn more about Rule 701, recent updates, and how to stay compliant at your company. Everything from the history of Rule 701 to the most recent changes.
Unlike public companies where value is set by the market, private companies use independent appraisers to assess their value. An IRS Section 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock that determines the “strike price” for equity. If your company is planning to offer options, you’ll need a 409A valuation.
We’ll help you understand the basics of 409A, so you can make an informed decision when choosing a valuation provider.
What we’ll cover
Section 409A was added to the Internal Revenue Code on January 1, 2005, primarily in response to the Enron scandal as a way to prevent executives from taking advantage of loopholes in equity compensation. At Enron, executives sped up payments associated with equity before the company went under. 409A and its subsequent provisions created a regulatory framework for private companies to adhere to and, in effect, level the playing field and avoid future Enrons. Final regulations for 409A were issued in 2009.
Section 409A forces companies to issue their common stock at or above the FMV. The IRS can assess penalties (to employees, NOT the company) if option strike prices are not at least at the FMV of the Common stock. A way to avoid these penalties is for companies to establish safe harbor.
The IRS requires companies that have issued (or plan on issuing) option grants to get a 409A valuation in order to maintain their safe harbor status. Early-stage companies and founders need to be aware of this inevitability to prevent their shareholders from having to pay onerous 409A penalty fees.
A simple guideline: if you are issuing options as an early-stage firm and expect to grow and anticipate eventual success, find a reputable 409A provider. To establish safe harbor, the 409A needs to be completed before they issue their first common stock option grants.
409A valuations are valid for a maximum of twelve months after the effective date, or until a material event. A material event is an event that could reasonably be expected to affect a company’s stock price. For the majority of early-stage startups, a qualified financing is the most commonly encountered material event. A qualified (or arm’s length financing) typically includes a significant sale of common shares, preferred equity, or convertible debt to independent, institutional investors at a negotiated price.
Whether or not an event outside of a financing is material is specific to each company. These events include acquisitions, divestitures, a secondary sale of common stock, strategic pivots in business models, and largely missing or exceeding previous 409A financial projections. If you aren’t sure, reach out to a 409A valuation provider or consult your lawyer.
- You should get your first 409A valuation before you issue your first common stock options, which is most often to your first hire or advisor
- After raising a round of venture financing, you need a new 409A valuation, as the previous 409A becomes obsolete when the new round is raised
- When your company matures (has more than ten employees/post-Series A) you should get a new valuation every twelve months, or after each material event, to maintain safe harbor.
- If you’re approaching an IPO, merger, or acquisition you may be required to get 409As more frequently due to external audits.
The cost of a 409A varies and can range from $1000 to $7,000. It’s important to select an independent, reputable provider. Different providers offer either a one-time fee or a subscription model. With Carta, we offer both 409A valuations and cap tables, which allows us to offer a lower price for 409A valuations.
At the end of the 12-month period, your company will need what Carta calls a “409A refresh” or an updated 409A valuation. There are instances when a company will need a 409A refresh before the 12-month safe harbor window expires. These instances include a new qualified financing round of equity or debt financing or a material event that may change the valuation of the company.
409A safe harbor means you’re protected from IRS audits. If you have safe harbor, the IRS must accept the valuation unless they can prove that the valuation is “grossly unreasonable.” If you’ve had a 409A valuation in the last twelve months and haven’t had any material events that change the value of your business, like a round of financing, you have 409A safe harbor.
The IRS provides three safe harbor methods for setting the FMV of the common shares of private companies:
- Independent Appraisal Assumption
- Illiquid Startup Presumption
- Binding Formula Presumption
The most common is the Independent Appraisal Presumption. This method is used by 99% of all private companies. With this method, a 409A valuation is performed by a qualified independent appraiser using traditional appraisal methodologies. The valuation is presumed reasonable if the stock was valued within 12 months of the applicable option grant date and no material change has occurred between the valuation date and the grant date. If these requirements are met, the burden is on the IRS to prove the valuation was “grossly unreasonable.”
The Independent Appraisal Presumption is why the 409A industry exists—private companies need an objective third-party to determine the FMV of their Common stock.
When it comes to 409As, you’ll want the lowest strike price possible, while still accurate valuation methods. The lower the strike price of an option, the more the option holder will receive when they sell the underlying stock.
The Market Approach, Income Approach, and Asset Approach are the three most common methodologies valuation providers use during a 409A:
1. OPM Backsolve (Market Approach)
When your company raises an equity financing round, valuation providers typically use the OPM Backsolve method. It can be safely assumed that new investors paid a fair market value for the equity, but investors receive preferred stock. So, adjustments must be made to determine the fair market value for common stock. which is used to estimate the company’s common stock FMV. Other Market-based Approaches use financial multiple information (revenue, net income, EBITDA, etc) from publicly traded comparable companies to estimate the company’s equity value.
2. Income Approach
If companies have sufficient revenue and positive cash flow, valuations providers often use the straightforward Income Approach.
3. Asset Approach
For very early-stage companies who have not raised money and don’t generate revenue, the Asset Approach is often used. This approach calculates a company’s net asset value to determine a proper valuation for a company.
Once you’ve selected your independent appraiser, you’ll need to start compiling the information necessary for the valuation firm to perform your 409A.
Below is Carta’s list of requirements, and most valuation firms will have a similar list. Gathering these documents can also be useful to make sure you have an up-to-date cap table and understand the state of your business.
- Name of your CEO
- Name of your external audit firm, if applicable
- Name of your legal counsel
- Your amended and restated Articles of Incorporation
- Your industry
- Relevant public comparable companies (most 409A valuations rely on some form of comparison to publicly traded companies when determining the FMV)
Fundraising and options
- The most probable timing of an eventual liquidity event
- The number of options you expect to issue in the next twelve months
- Your company presentation, business plan, or executive summary
- Financial statements
- Forecasted revenue for the next 12 months (from the Valuation Date) and the next 2 calendar years
- Forecasted EBITDA for the next 12 months (from the Valuation Date) and the next 2 calendar years
- Cash burn and runway
- Non-convertible debt amount
- Any materially relevant events since your last 409A valuation or any material events in your company’s history if this is your first 409A
If the valuation is performed outside of the safe harbor methodologies listed above and a company violates section 409A, the penalties fall on the employee and not the company. You should protect your employees and find an objective and reputable third-party because the penalties for Section 409A violations are severe: they include an immediate tax on vesting, an additional tax of 20%, and penalty interest.
Most startups won’t have to face an IRS audit. But if your company is successful and you are approaching an exit (M&A or IPO), you will definitely face audits. You’ll save yourself a lot of time and effort down the road by selecting a reputable provider up front.
Example 409A valuation report
409A compliance is necessary for private companies that issue options to employees.
There is a lot of other information that you’ll eventually become aware of when the 409A process begins (valuation methodologies, FMVs and valuation industry averages, how the industry is changing, etc.). But you now have an understanding of the basics to make sure your company is compliant with IRS section 409A.
We hope this post helps you make an informed decision about a 409A provider.
At Carta, we provide audit-defensible 409A valuations. We’re the country’s leading cap table management and 409A provider, and perform approximately 5,000 409A valuations each year. We leverage best-in-class software and industry expertise to deliver valuations faster and for less than traditional providers. Please get in touch if you’d like to learn more about us.