• April 13, 2016

9 Signs Your Startup Needs a 409A Valuation

9 Signs Your Startup Needs a 409A Valuation

One tax law that flies under the radar for new founders, yet impacts startups greatly, is the Internal Revenue Code (IRC) Section 409A. Basically, Section 409A regulates nonqualified deferred compensation, which for startups typically comes in the form of granting employees stock options instead of a higher salary. 409A Valuations are designed to help companies set the strike price for their employee stock options as Section 409A states that they need to meet or be above fair market value.

What came about after the dot com boom (and the influx of cheap stock grants & wealth creation as a result), 409A is part of the American Jobs Creation Act of 2004 and was added to the IRC in January 2005.

Here are nine questions that signal you need help with your 409A:

Who needs it? 

According to Mercer Capital, “Section 409A applies to all companies offering nonqualified deferred compensation plans to employees…. Generally speaking, a deferred compensation plan is an arrangement whereby an employee (“service provider” in 409A parlance) receives compensation in a later tax year than that in which the compensation was earned.” It is intended to limit the ability for folks to control when they are compensated, and subsequently taxed on that compensation. The scary thing for startups is that if they don’t comply, their employees can be liable for taxation. Doesn’t make for very happy employees…

What’s the difference between qualified and nonqualified deferred compensation plans? 

Qualified: It’s really important that the common stock be valued correctly at or above fair market value because Section 409A does not apply to NSOs (nonstatutory stock options) to purchase Common Stock if it meets those requirements at the time of grant. 409A also does not apply to ISOs (incentive stock options), pension and 401(k) plans, as well as welfare benefits like sick days, vacation leave, disability pay, etc.

Nonqualified: In layman’s terms, nonqualified deferred compensation can take the form of stock options, stock appreciation rights, etc. – and typically that form of compensation vests and becomes taxable in two separate years.

What is fair market value?

Technically speaking, fair market value (FMV) is the price that property would sell for on the open market, typically agreed upon by willing buyers and seller. It provides significant knowledge of facts and requires neither party to act on that value. In this case, an appraiser is required to perform a 409A valuation to ensure it is fair and based on market knowledge.

Who can give me my 409A valuation?

To reduce risk, ensure you work with a qualified third party to perform your 409A valuation, typically a bank or valuation / appraisal firm. VENTUREAPP can find you the best 409A solution provider that fits the size & stage of your startup.

When do I need it?

You must value your stock options around a value creation event (such as the launch of a new product, a recent financing event, etc.) AND the value calculated cannot be more than 12 months old. So you need a new 409A every single year if you want to offer stock as compensation and provide a safe harbor to employees re: potential tax liabilities. As you grow but remain private, you should receive a new valuation more frequently.

How much does it cost?

For your 409A, you’ll want an affordable option since you have to conduct it annually, but also a firm that works fast & is high quality and low-risk for your business. Depending on size and stage, startups can expect to pay anywhere from $1,500 to $5,000 per valuation. Curious whether you’re getting the right quote on your 409A? If you’re paying more than $2,700, check with VENTUREAPP to see if we can benchmark & find you a 409A option that better fits your business.

What factors influence the value of my common stock?

The more valuable the company, the more worth your common stock holds. According to Morse Barnes-Brown Pendleton, below is the typical valuation method & factors that can influence the value of your company’s common stock:

  • the value of tangible and intangible assets of the company
  • the present value of anticipated future cash-flows of the company
  • the market value of stock or equity interests in similar companies engaged in a similar business
  • recent transactions involving the sale or transfer of such stock or equity interests
  • control premiums or discounts for lack of marketability
  • whether the valuation method is used for other purposes that have a material economic effect on the company, its stockholders, or its creditors.

What happens if I don’t get a 409A valuation?

You could be challenged and audited by the IRS. Basically, employees become liable – they are taxed, receive a 20 percent penalty which is required to be included in the gross income, and potential interest payments on the taxable amount. Pretty severe & compelling reasons to comply.

How do I know which auditor is best to work with?

Typically, a bank or valuation firm can assess you startup’s situation and is the best bet from a economic & low-risk perspective. You want to go with an institution that will get the job done correctly the first time around – so it doesn’t become something you worry about later in the year. According to Silicon Valley Bank, a solid 409A valuation provider should follow methodologies approved by both the AICPA Practice Aid and IRS regulations. Further, they should provide you an auditable report for taxes & financial reporting, and benchmarks based on other similar size & stage startups to instill confidence that your valuation is correct and able to stand up against a potential audit.

Need help finding a 409A valuation provider? As a reminder, we can find the most reputable providers, at the best cost, for any stage startup. Just fill out this quick form to get started.