Section 409A of the Internal Revenue Code, and the Section 409A Treasury regulations, are U.S. federal tax laws and regulations that effectively require companies to grant stock options with an exercise (or strike) price at or above the underlying shares’ fair market value as of the grant date. If an option is granted with an exercise price below fair market value, the option recipient may have to pay income taxes, interest, and penalties, potentially negating the option’s economic benefit. If the option recipient is an employee, the company must also withhold income and employment taxes on an underpriced option. Failure to do so could result in the company paying interest and penalties on the under-withheld amounts.
Obtaining a valuation from a qualified, independent appraiser and using the appraised value to set the option exercise price is a “safe harbor” valuation method under the Section 409A regulations. If a company doesn’t use a safe harbor method, it bears the burden to prove its value determination was reasonable if challenged by the U.S. Internal Revenue Service (IRS). This can be difficult and time-consuming, often involving extensive correspondence and accountants’ fees. A safe harbor valuation method provides a presumption of reasonableness, meaning the burden shifts to the IRS to prove that the valuation was “grossly unreasonable.”
A company’s 409A valuation report is valid for 12 months following the valuation date (which isn’t always the same as the report date) or until a material event affects the company’s value, whichever comes first. Therefore, expect to obtain a new 409A valuation at least annually, or more often if your company is fundraising or reaching other critical milestones during that period. Many startup lawyers view signing a term sheet for equity financing as an event that causes a 409A valuation to expire.
Obtaining a third-party 409A valuation is among the simplest safe harbors to qualify for and can serve as inexpensive insurance against avoidable tax issues. If a company doesn’t get a valuation report to set its option exercise price, it may end up spending more to address questions about potential tax consequences in the middle of a financing or M&A transaction than it would on the 409A valuation.
Valuation costs can vary based on the company’s stage, the number of stockholders, and the time frame for completing the valuation. Subscription valuation services, often bundled with cap table management software, are now available to help companies keep their valuation reports up to date.
The process of engaging a 409A valuation firm, providing necessary information, reviewing a draft report, and finalizing the valuation typically takes two to six weeks. The company will need to provide an updated cap table, financial statements and projections, and schedule a call between the appraiser and company management. Be aware of this timeline to avoid delays.
Some founders worry that a 409A valuation, especially one with a low fair market value, might negatively affect the valuation an investor or acquirer assigns to their company. However, this concern is unfounded. Sophisticated investors and acquirers value companies differently and for different purposes than valuation firms. They care more about whether a company has diligently obtained 409A valuation reports for its option grants than the specific value indicated in the reports. In fact, a lower 409A fair market value can make a company more attractive to employees and recruits. This is because the company can grant its stock options with a lower exercise price, leaving more room for an increase in the value of the shares. Experienced valuation firms understand this and will work with companies, within reasonable limits, to establish lower, yet still defensible, fair market values.