16 Things To Know About The 409A Valuation

When startups grant stock options – which are important for attracting talent – how do they determine the value of common shares? For a privately-held company, the 409A valuation is the only method you can use to grant options on a tax-free basis to your employees. (For more on how startup options work and key terms involved, please see this post.)

However, a 409A valuation can often feel like a black box to many people, especially as it has evolved so much over the 15 years since it was first introduced. It’s changed from a hodgepodge of now-outdated techniques and loose ranges, to a set of more established, well-defined methodologies and inputs.

In broad strokes, a 409A valuation is a three-step process: The first step determines how much a company is worth (i.e. “enterprise value” – more on that below). The enterprise value is then allocated across the various equity classes to arrive at the fair market value (FMV) for the common stock. Finally, the last step is to apply a discount to the FMV to take into account that the stock is not publicly traded.

I’ve been involved in 409A since its early “Wild West” days, when I was a CFO overseeing the process at startups, and now work with our portfolio companies – particularly early stage founders – on the valuation process. Because it’s so important for founders, Boards, and employees to understand, below I share the basics of 409A valuation; different methodologies for calculating the key valuation drivers; and some of the most common myths about them – and the unintended consequences that can result.

For the purposes of this article, we assume your company is a U.S.-headquartered Delaware C-corp granting vanilla call options (simple expiration date and strike price, no special terms or features) to U.S.-based employees. While this post covers the most critical points, the American Institute of CPAs (AICPA) publishes the definitive guide “Valuation of Privately-Held-Company Equity Securities Issued as Compensation” on all of the generally accepted methodologies and techniques with easy-to-follow case studies.

But first, how did we get here?

In the U.S., prior to 2007, stock option grants were not considered taxable events. Stock options (and other forms of tax-deferred compensation) were taxed only when an employee actually exercised their options to buy the common stock.

So what changed? In a word: Enron.

In the U.S., prior to 2007, stock option grants were not considered taxable events. So what changed? In a word: Enron. Now, for grants to be tax-free events, companies must comply with Internal Revenue Section 409A. Click To Tweet

In the years leading up to its bankruptcy in 2001, Enron executives committed a number of misdeeds. Among them, those who were granted large stock options awards accelerated the vesting of their options and then exercised and sold stock when the company’s shares were trading at all-time highs, all the while knowing they were overstating the value of the business to drive up the company’s valuation. As the fraud came to light, it highlighted loopholes in non-retirement tax-deferred compensation that until then had largely been ignored by Congress. The Enron stock option fraud was not covered by existing insider trading laws, so as a response, Internal Revenue Section 409A was passed as part of the 2004 American Jobs Creation Act.

In a nutshell, Section 409A excludes stock options from the U.S. definition of “tax-deferred compensation,” unless certain rules are followed. Companies can largely ignore Section 409A if they give employees stock options that have a strike price (the price at which the stock can be bought) exactly equal to the fair market value (FMV) of the common stock at the time of the grant. For publicly-traded companies, where the fair market value is the current stock price, this is easy. But it’s not straightforward for privately-held companies, such as startups.

As a concession, provisions were created so that privately-held companies could determine the FMV of their common shares in a way that would be accepted as valid by the IRS – what is known as “safe harbor.” However, the new standards of proof were a radical change from how privately-held companies had previously determined the FMV of their common stock. Whereas in the past, a company would decide on its own (with advice from the Board and outside counsel) what they felt was an appropriate price, they would now have to provide substantial supporting evidence.

Getting Started with 409A

#1 Why should I hire a 409A valuation firm?

In order to structure stock option grants as tax-free events to your employees, you need to prove what you calculated as the fair market value of your common stock is reasonable, otherwise known as “safe harbor.”

The easiest and most common way to ensure 409A safe harbor is to have a qualified, independent valuation provider conduct the 409A analysis. A good analogy here is when your mortgage lender uses an appraiser to figure out how much your house is worth: They don’t want to know what you think since you’re biased – they want the value determined by someone who can give them a dispassionate, arm’s-length assessment.

Having said that, hiring an expert doesn’t automatically guarantee 409A safe harbor. As the CEO/founder, you still have a duty to ensure the valuation work is reasonable and defensible because the IRS (and the SEC, where applicable) can challenge the analysis, even if it’s performed by an independent provider.

#2 How should I select my 409A valuation firm?

You want to select a provider who has experience valuing companies that look a lot like yours. A valuation provider should have not only the right credentials and expertise conducting valuations to ensure 409A safe harbor, but also extensive experience in your sector, industry, and stage.

For instance, don’t engage a valuation provider whose clients are primarily companies located in the Midwest that are slow-growing, profitable brick-and-mortar businesses if you’re a high-growth yet unprofitable enterprise SaaS company headquartered in Silicon Valley (and yes, I have helped companies where this has happened!). Think of it as analogous to selecting a tax provider to do your personal income taxes: You would choose a tax accountant who is not just certified as a CPA, but also has extensive experience filing taxes for someone just like you, so you can leverage their experience across those similar clients to optimize your tax return without triggering audit flags.

You also want to select a valuation provider who has strong relationships at major audit firms – the Big-4 accounting firms (Deloitte, PWC, KPMG, and E&Y) and/or large regional firms in your area – with the relevant sector heads/partners at that firm’s venture practice. This is a good indicator the valuation firm has proven their work is defensible and respected by experts in the audit community.

Daniel Knappenberger, Silicon Valley Market Leader at Deloitte Advisory notes that “for private companies, a 409A analysis is very important and it is critical to have the right level of support for any conclusion of value. Working with a valuation advisor who has the relevant experience can help companies shape their point of view and save them a lot of potential pain down the road.”

#3 How often should I do a 409A valuation?

Companies are expected to conduct 409A valuations at least once every 12 months, or when a material event has occurred that would affect the value of the company – whichever occurs sooner.

“Material events” can include new equity financings; an acquisition offer by another company; certain instances of secondary sales of common stock; and significant changes (good or bad) to a company’s financial outlook. A company credibly approaching IPO will also conduct 409A valuations more frequently (e.g. quarterly or even monthly).

#4 What do I need to do a 409A valuation?

The data you need to provide to your 409A provider is relatively straightforward, and your 409A provider will spend time with you to get additional context on your company and any unique circumstances you may have.

  • Your sector / industry
  • Most recently amended articles of incorporation: Also known as the corporate charter, or certificate of incorporation; your outside counsel will have this if you don’t.
  • Most recent cap table: Again, your outside counsel will have this if you don’t.
  • Board presentation and recent pitch deck (if you just completed a fundraise)
  • Company historicals and 3-year profit and loss (P&L), cash balance, and debt projections: If you’re an early stage company, this is a best effort, as it’s hard to predict where a company will be in 12 months, much less three years.
  • Estimate on how many options you expect to issue over the next 12 months: A good back-of-the-envelope estimate is take your hiring plan and multiply this by the median number of options per employee, adjusting for any “option expensive” hires (e.g. VP and C-level executives, Director of Engineering).
  • A list of 5+ publicly-traded companies most comparable (“trading comps”) to yours: If your company doesn’t fit into an exact category, that’s okay – most founders start disruptive companies, so it’s not uncommon to not fit perfectly into an existing industry. However, make sure the comps make sense to you because they will be part of your subsequent 409As. Your comps should only change if someone is acquired or new companies go public that make sense to include.
  • Timing expectations around potential liquidity events (e.g. IPO, M&A)
  • Significant events that have happened since your last 409A

#5 How long does a 409A valuation take?

Generally, if you have all the items in the above checklist, it takes about two weeks to get to a final draft of your 409A valuation for your Board to approve. For later-stage companies who have engaged an auditor (more on that in #6), the timeline may be a little longer.

A typical timeline involves data collection and kick-off calls, valuation modeling, preparation of draft schedules, and management review in the first two weeks; and then obtaining Board approval and granting options the third week.

#6 How involved should my auditor be?

For most startups, once you reach around $10M of annual revenue, investors will expect you to start presenting audited financials. The 409A valuation is a key driver in calculating stock compensation expense, so your auditor will most certainly review it. Involving them early in the 409A valuation helps to ensure a smooth audit process.

As a best practice, include the audit team in the kick-off call with you and your 409A provider prior to conducting a new 409A valuation. In this call, it’s important that everyone agrees on the approach and valuation methodology (which we’ll cover in “The Calculations” section below). If the valuation is complex enough, or you’re anticipating an IPO within the next two years, then the auditor may request that their valuation specialist review a draft of the 409A valuation before you finalize it for Board approval. This sign-off step will add a minimum of one week to the timeline.

It’s critical to get everyone on the same page. In the event your auditor identifies a flaw in a 409A that you’ve used to grant options, they will require you to revisit (and potentially revise) not just that 409A valuation, but also prior 409A valuations. This can be a lengthy and painful process, and any option grants that are outstanding will be put on hold until the 409A valuations are sorted out.

409A Valuation Calculations

In this section, we break down the three steps that are involved in the 409A valuation itself.

  1. Calculate enterprise value. The first and arguably most important step is estimating the company’s valuation (“enterprise value”). This is very straightforward if you’re doing your 409A valuation immediately after a fundraise, but becomes fuzzier a year (or more) after the fact.
  2. Determine the value of the common stock. The second step is to take that enterprise value and divvy it up among all the different share classes (e.g. preferreds, warrant holders, common) to determine the current value of the common shares – what is also known as the “fair market value” (FMV). This step takes into account all of the economic rights of each share class, otherwise known as liquidation preference (i.e. the order in which stockholders are returned their investment in a liquidity event) and rights related to conversion, dividends, and participation.
  3. Apply a discount for lack of marketability (DLOM). The third and final step is to take the calculated FMV for the common shares and apply a discount to adjust for the fact that the company is not publicly traded – in other words, none of your employees could actually go and sell their shares at that price because there is no liquid market for them.
The 3 steps to 409A Valuations: 1) Calculate enterprise value. 2) Determine the value of common stock. 3) Apply a discount for lack of marketability. Click To Tweet

#7 Calculate enterprise value

While there are many ways financial experts (e.g. M&A experts, equity research analysts, VC firms) can determine enterprise value, in 409A valuation work, there are three main methodologies: market, income, and asset-based. These can be used in combination with each other and the method(s) may change as a company matures. For instance, it’s common for early stage companies to rely heavily on a market approach, while more mature, growth-stage companies are more likely to use an income approach.

MARKET APPROACH

When it’s used: For unprofitable, early stage companies where it’s difficult to predict long-range financial performance.

How it works: The market approach is a relative valuation method, which means the company is compared to a set of publicly-traded companies (“trading comps”) that are similar to it, usually by industry. This comp set is then used to determine the appropriate valuation multiple to apply to the company’s own set of metrics to arrive at an enterprise value. For profitable companies, this is typically an EBITDA multiple, but in the case of early stage companies where EBITDA is often negative, revenue multiples are used. This is called the Guideline Public Company method.

Pros & Cons: The benefit of this methodology is it’s very easy to calculate publicly-traded company multiples. The limitation is oftentimes the comp set may not be a great representative peer group because the company doesn’t fit perfectly into a particular category. Many startups are trying to create new industries/markets, and so in these cases, by definition their comps will be imperfect since nobody else is doing what they do. More often than not, the company is also growing at a very different rate compared to its publicly-traded comps (hopefully much, much faster), but also at a very different scale (startup: small vs. public companies: very large), so adjustments are made to try to take into account that the comparison is not perfect.

If you’ve just completed a fundraise, determining enterprise value is actually very straightforward: the valuation of that round is used. This is called a backsolve and will almost always be the way a founder will first encounter a 409A valuation, since they’ve now received funding and can hire their first employees. A backsolve is considered a “market approach” for calculating the enterprise value of a company, but instead of building public comps and applying multiples to metrics (as with the Guideline Public Company method outlined above), that round’s valuation is used as the anchor to back into (backsolve) the implied total equity value of the business based on the given mix of share classes and their rights and preferences.

The 409A provider is able to use the valuation from that fundraise because the new preferred investors (e.g. VC firms) are assumed to be sophisticated, with the transaction done at arm’s length, with both buyer and seller acting independently from each other and in their own self interest.

INCOME APPROACH

When it’s used: The income approach is used primarily by companies who have achieved scale, a high degree of visibility and predictability in their financial performance, and line of sight to when they expect to become profitable.

How it works: This methodology assumes that a company’s value is determined by the receipt of future profit streams. The company’s long-range financial projections are used to determine what these income levels are, which are then discounted back to what they would be worth in today’s dollars (“present value”). The income approach is also called the discounted cash flow (“DCF”) method.

Pros & Cons: The benefit of this methodology is it’s directly influenced by the future expected profit from the company. The downside is it requires reliable long-range forecasts that must be substantiated. Danny Wallace, Co-Leader of the Emerging Companies Services Group at PwC notes “the income approach requires the most audit effort. The reason is it involves assumptions that are inherently subjective, such as revenue growth, customer attrition, gross margins, and operating expenses, which become progressively more difficult to forecast the further out you go in the 10 years of the cash flow period. Without a relatively sophisticated FP&A [financial planning & analysis] function in place, companies may struggle to provide sufficient support to satisfy their auditors.”

ASSET APPROACH

When it’s used: For venture-backed companies, the asset approach is rarely used; when it is, it is typically in the very early stage before any formal (i.e. pre-angel) financing occurs. For instance, a very nascent life-sciences company funded only through academic grants would be a candidate for the asset approach.

How it works: This approach uses replacement cost to determine a company’s enterprise value. For this method, the appraised value of all the assets and liabilities of the company determine its enterprise value.

Pros & Cons: The benefit to the asset approach is it doesn’t require any kind of forecasting because the potential growth of the company is completely ignored. This is also the downside to the asset approach. Additionally, it can be prohibitively expensive to appraise certain assets and liabilities – especially intangible assets such as IP – making this an impractical method for early stage companies.

Once a company’s enterprise value is determined, the next step in a 409A valuation is to assign the various equity classes their fair share of the company, taking into account economic rights such as liquidation preferences, participation rights, and conversion ratios.

#8 Determine the fair market value (FMV) of the common stock

In the case of a company with only common shares (extremely rare for a privately-held, venture-backed company), the FMV would just be the enterprise value divided by the fully diluted shares outstanding. However, most privately-held venture-backed companies have at least two, if not more, classes of equity (e.g. Series A/B/C/D/etc. preferred shares along with common shares). In these cases, calculating the FMV of the common shares requires further analysis.

There are three ways to allocate the enterprise value across multiple share classes. We’ll go from most often used for VC-backed companies, to least.

OPTION-PRICING METHOD (OPM)

How it works: All of the company’s various classes of stock are treated as if they are call options and assigned exercise prices (the price at which the option holder can buy the stock). In the case of preferred stock, the exercise price is determined by the liquidation preference. In the case of common stock, the money left over after all of the liquidation preferences have been satisfied is used to determine its exercise price. In the unfortunate situation where a company is acquired for less than or equal to the liquidation preferences, the shareholders of common stock receive $0 (assuming no management carve outs).

When it’s used: OPM is most frequently used for companies that are still too early in their development to identify specific exit scenarios and their timing.

Black-Scholes: Black-Scholes is the most commonly-used option-pricing model in a 409A valuation. We won’t go into a lengthy technical explanation of how it works, but at a high level, the Black-Scholes model calculates the value of an option by averaging all the possible future “profit” on that call option’s strike price (i.e. future stock price >= current option strike price, otherwise known as when an option would be “at or in the money”).

For a 409A valuation, a handful of key assumptions drive the output of the Black-Scholes model: the enterprise value of the company (explained above), volatility, and the expected time to exit (TTE).

Your company’s volatility is determined using the set of publicly-traded companies that were identified as your “trading comps” from step 1. The more volatile a stock, the higher the chances the option will expire in the money, which increases its value. As with the case of determining the appropriate multiple to use, adjustments are made to take into account the imperfect nature of the trading comp set.

The expected time to exit is simply the amount of time until a liquidity event (e.g. IPO or M&A). The longer the time to exit, the more valuable the option, since more time gives the option an increased chance to expire in the money.

PROBABILITY-WEIGHTED EXPECTED RETURN METHOD (PWERM)

How it works: In this method, various outcomes – specifically IPO, M&A, dissolution, or continued operations – are modeled at their projected values and then each is assigned a level of probability of occuring, with how each share class participates in those outcomes dictated by their respective rights. Common stock values tend to be higher in PWERMs than in OPMs because in the IPO scenario all of the preferred stock converts to common, which eliminates the liquidation preferences.

When it’s used: This method is most frequently used for companies that have matured to the point where they can estimate with reasonably strong confidence potential exit scenarios along with their timing (e.g. IPO in 18 months).

HYBRID METHOD

How it works: The Hybrid Method is a combination of using both OPM and PWERM, estimating the probability-weighted value across multiple scenarios, but using OPM to estimate the allocation of value within one or more of those scenarios.

When it’s used: The Hybrid Method can be a useful alternative to explicitly modeling all PWERM scenarios in situations where the company has insight into one or more near-term exits (e.g. M&A in 6 months), but is unsure about what would occur if those specific plans fell through.

CURRENT VALUE METHOD (CVM)

How it works: This method estimates the company’s present-day equity value (in other words no assumption of future progress) and assumes there is an immediate sale or dissolution of the company. Value is then allocated across the share classes based on liquidation preferences, conversion ratios, and participation rights.

When it’s used: For a venture-backed company, it’s very rarely used. The only time the CVM makes sense is when the company is at such an early stage that either no material progress has been made vs. the company’s expectations (and thus no value above the liquidation preference has been created) or there is no way to reasonably estimate a time when the company could create value above its liquidation preference.

#9 Apply a Discount for Lack of Marketability (DLOM)

The last step in a 409A valuation is to apply a discount for lack of marketability (DLOM) to the common stock value calculated in step 2. The equity allocation models used in step 2 assume there is an active market to immediately buy and sell the common stock – in other words, fully marketable (publicly-traded) stock. This isn’t the case for the majority of privately-held companies and so their common stock is less valuable because of a “lack of marketability.” To adjust for this, a DLOM is applied to the calculated fair market value.

This lack of marketability decreases as the company scales and becomes more and more likely to be successful. A company who has just raised a Series A may have no interested buyers in its common stock and therefore has a very large DLOM, whereas a company who has reached scale and is a credible candidate to be a publicly-traded company has a very small discount.

The primary variable that affects the size of the DLOM is the time to a liquidity event. In other words, how long will the owner of the shares have to hold onto them before they can be openly exchanged and sold? Most DLOM studies conclude a discount in the 25%-35% range for a two-year holding period. Discounts greater than this are reasonable if the time to a liquidity event is many years in the future.

In the case of a backsolve (see #7), your DLOM will actually likely be lower than these ranges because the 409A valuation is benchmarking to a preferred instrument, which implicitly incorporates a certain lack of marketability into the pricing from the VC investor.

409A Valuation Myths

Companies want to keep the common FMV low since it makes stock options seem more lucrative to employees and recruits. However, pursuing the lowest possible value at all costs can create serious consequences for your company and your employees. While the 409A valuation framework has become well established, some myths from the early days have persisted. In this section, we bust the four most common.

#10 MYTH: Your common stock is worth 20% of the last round’s price

Gone are the days where a private company, working with its Board and outside counsel, could just use a rule of thumb to set common stock FMV at 10-20% of the most recent preferred round (yes, this really was how option strike prices used to be set at private companies!). Only in rare instances is a privately-held company’s common stock FMV legitimately 10-20% of the value of its preferred stock – even with early, seed-stage companies.

So, if anybody tells you your 409A is too high and should be “X% of the preferred,” they’re giving outdated advice. “Percent of preferred is one of the most misunderstood – and anachronistic – metrics in the venture world,” notes Bob Chung, Director of Valuations at Carta. “The ratio is highly dependent on a given company’s ability to negotiate favorable financing terms at a specific point in time. It can’t be applied as a benchmark across a range of disparate companies.”

The truth is without running through an actual 409A valuation analysis, no one can know what the FMV of your common stock should be off the top of their head. There is no “rule of thumb,” and every company is unique. I’ve seen valuations come back that sounded way too low, but it turned out they were reasonable because of the economic rights of the preference stack; I’ve also seen FMVs that seemed way too high but were in actuality reasonable because of the significant progress the companies had made since their last 409As or because the methodology justifiably changed.

Without running through an actual 409A valuation analysis, no one can know what the FMV of your common stock should be off the top of their head. There is no “rule of thumb,” and every company is unique. Click To Tweet

#11 MYTH: You can use a different forecast for your 409A valuation than your Board forecast

In the early days of 409A, this was a commonly-used tactic, but companies can no longer get away with it. While it may be tempting not to give your 409A valuation provider the true company forecast – the one that you’re reporting to your Board – and instead provide an artificially low set of projections to try to keep the value of your common stock low, the company’s forecast is one of the very first places someone will look to make sure the assumptions used in the analysis were reasonable. They will verify this was the version you were using to run the business; if it isn’t, it will cause issues with your auditors (where applicable), and invalidate the 409A safe harbor, opening up huge risk to your employees.

#12 MYTH: Do whatever it takes to get the lowest strike price

When it comes to strike price, small changes you manage to squeeze out of your 409A aren’t going to make much of a difference to your employees’ take-home when there is a meaningful liquidity event. Let’s walk through the math on how the economic difference of pennies, dimes, or even dollars in strike prices won’t have a significant material impact in the big picture of a liquidity event:

As an example, let’s say an employee is given an initial grant of 100,000 options with a strike price of $0.35. Six years later, the company has an exit where the common shares are worth $50. Here’s this employee’s take home before taxes on that grant:

($50 – $0.35) x 100,000 shares = $4,965,000

Now let’s say instead of $0.35, the strike price at the time of that employee’s grant had been $2.00. Then the take home before taxes would have been:

($50 – $2.00) x 100,000 shares = $4,800,000

While the difference between the two strike prices of $0.35 and $2.00 looks significant (471%!), the actual financial outcome had a 3% difference.

The key takeaway here is it’s important to keep things in perspective. Your common stock is going to appreciate in a way that’s reflective of the progress you’re making in building your company. Keep in mind: doing things that could invalidate your 409A safe harbor will open up your employees to significant taxes and penalties (see #15), dramatically reducing what they net from their options. If you feel the FMV is starting to “sound expensive” from an ability-to-recruit-new-hires perspective, you can consider doing a stock split to get the strike price back down to a level you feel makes you sound more competitive.

#13 MYTH: The strike price must be exactly the same as the 409A FMV

While you can’t choose an option strike price that is lower than the 409A valuation’s calculated FMV, you can set a strike price that is higher. The relevant regulatory and tax authorities are generally only concerned when the strike price was set at a level that was lower than the 409A valuation supported: For the IRS, it would mean employees had actually received discounted (“in the money”) stock options that then would have been taxable at the time of grant; and for the SEC, it would indicate that the company was understating its stock compensation expense to artificially improve its profitability.

Setting the strike price higher than the 409A FMV can be useful in situations where the company’s enterprise value (see #7) has declined since the last 409A valuation. Such cases include when the prior 409A valuation is now significantly ahead of the company’s current traction (and the new 409A is therefore lower), or in a down-round situation. In these instances, the company can opt to keep the strike price “flat” – the same value as the prior 409A valuation – to preserve employee morale. However, be realistic when making this kind of decision: what will likely happen between now and the next 409A; are you confident this is just a one-time blip in the company’s progress?

Good intentions, unintended consequences

In this section, we cover a few of the consequences of having an overly-aggressive 409A valuation. “Your 409A follows you around, and shows up in secondary transactions, tax issues, audit review, and of course, in the pre-IPO phase” notes Steve Liu, Head of Shareworks Valuation Services, “It’s got to be right.”

#14 Hurts employee morale

For early stage companies where an audit is more than two years away, the reality is there is less risk having an aggressive 409A valuation compared to larger, more established companies. Having said that, there will come a time when that window closes, as it inevitably does when you build a successful company. When it happens, you will face a significant step-up to your FMV as you come off a too-aggressive 409A and are effectively forced into a clean valuation.

Now you’ve inadvertently created a situation where one group of employees has very low-priced options and another group – some who will have started only days or weeks after the early group – with significantly higher priced ones, even though the business hasn’t changed that materially. Now you have a world of “haves” and “have-nots,” because inevitably, employees will talk to each other and resentment can then build up. This issue will stay with you, coming up every time you have compensation discussions involving those employees.

#15 Creates significant tax burdens for your employees

The financial consequences for 409A non-compliance can be severe to your employees. If the IRS were to get involved and determined your 409A valuation didn’t fall under safe harbor, all of the stock you granted to your employees under that FMV – not just the current taxable year, but any prior year – become included as part of their gross income (including interest owed) all at once in that year. The IRS can also levy up to a 20% penalty on stock options that vested prior to that tax year.

As an example, let’s say you granted an employee 100,000 options that vest over four years at a strike price of $0.25. Two years after you granted these options, the IRS reviews your 409A valuation from that grant and determines the $0.25 FMV didn’t fall under safe harbor because of flawed methodologies, and the common stock actually had been worth $1.00.

Here is the math on what your employee would owe in that tax year at the federal level (we won’t walk through federal interest owed or what would be owed at the state level):

Federal income tax rate = 37% (assume highest bracket for a single filer in 2020)
Federal 409A penalty = 20%

Option grant strike price = $0.25
Current FMV in year 2 = $5.00
# of common shares vested at 2 years = 50,000
Taxable income = $232,500 (50,000 shares x [$5-$0.25])

Federal income tax = $86,025 (37% x $232,500)
Federal 409A penalty = $23,750 (20% x 25,000* shares x [$5 – $0.25])
Total federal taxes & penalties* = $109,775

*penalty only owed on prior year’s vested options, not current tax year

This $109,775 is actual cash the employee will have to pay to the IRS, and it doesn’t matter that the employee didn’t exercise their options to sell a single share, or that there was nobody to whom they could sell those shares even if they did exercise. Because the stock options were not granted at FMV in the eyes of the IRS, but rather 75% below FMV (at the $0.25 strike price), the option grants do not fall under safe harbor. As the options vests, this is considered taxable income – with a penalty tacked on for the taxes that weren’t paid on the prior year’s vested options. All over $0.75!

On top of this, there will be taxes owed in any future year where that option grant continues to vest. If FMV continues to increase, then the tax liability also increases:

Option grant strike price = $0.25
Current FMV in Year 3 = $6.50
# of common shares vested at Year 3 = 25,000
Taxable income = $156,250 (25,000 shares x [$6.50-$0.25])

Federal income tax in year 3 = $57,813 (37% x $156,250)

Again, it doesn’t matter whether this employee actually sold a single share or not! The IRS will expect them to pay $58K in income tax on that year’s vested options. (And this will happen for one more year since the options vest over 4 years.)

Worse, the tax issues won’t end with the federal government. State and local income taxes will also come into play. “The states have focused on equity compensation in recent years. California, in particular, reviews equity compensation arrangements to determine whether an employer and employee have reported correctly and routinely imposes penalties on top of a tax rate that can climb as high as 13.3%,” notes Eric Anderson, Managing Director of the SF Bay Area State and Local Tax practice at Andersen Tax.

Moral of the story: Always retain a qualified and independent 409A valuation firm, and make sure the valuation work is defensible so that safe harbor applies and option grants remain tax-free events for your employees.

#16 Negatively affects an acquisition or IPO

During M&A due diligence, the acquirer will review your 409A valuations. Generally speaking, bad 409A practices tend to look sloppy and won’t do you any favors to setting the tone for negotiations. If the buyer determines they aren’t comfortable with the 409A valuation(s), they can alter the terms of the transaction so that any financial burden associated with the mispriced options are not their responsibility, they can require that you indemnify them for the risk, or they can require that you pay (or force your employees to pay) any associated penalties and taxes related to the affected option grants.

From an IPO standpoint, the SEC will review option issuances for the 12-18 month period preceding an IPO. If there is a significant difference in the option strike price and the proposed IPO price, the SEC could determine the options were granted below their actual fair market value (and thus, “in the money”). This will generally require the company to take an accounting change related to cheap stock, which is not great to have to disclose to potential investors as it can be construed as a reflection of the quality of management.

Andy Barton, Partner at Goodwin & Procter LLP points out, “409A valuations are open to challenge by a variety of actors, including not only the IRS, but also potential buyers in a transaction, or the SEC in an IPO. It is imperative to get it right.”

The Bottom Line

A better approach to your 409A valuation: view them as part of the narrative of your company’s progress. Done well, you can tell a story that informs and inspires employees and candidates. Click To Tweet

Your 409A valuation is a direct reflection of the company building and shareholder wealth you’re creating. While you should absolutely work with your 409A provider to optimize the valuation, don’t resort to using questionable valuation methods and/or assumptions – doing this can have serious, unintended consequences, as we’ve outlined above.

A 409A valuation isn’t an exercise in “maximizing the minimum,” where the goal is to have the common stock appreciate as little as possible from the prior FMV. If that were the case, you’re making the claim that between your last 409A valuation and now, the company made almost no progress at all – meaning you created very little value. A look at your company’s KPIs and financial performance would provide anyone a quick assessment of whether this is actually true.

Don’t look at the current valuation in a vacuum – all your 409As are connected to each other. If your company is growing revenue quickly, but your 409A value isn’t to some degree keeping up, something is clearly fishy (unless you have a lot of structure to your preferred equity, such as participation rights).

A better approach to your 409A valuations is to view them as part of the narrative of your company’s progress. Ideally, the FMV of the common stock will have a nice smooth, upward progression that mirrors the growing success of your company. The appreciation in your common stock’s value is an opportunity to message the value proposition of your company. Done well, you can tell a valuation/wealth creation story that informs and inspires employees as well as new-hire candidates.

Many thanks to these other experts contributing their thoughts: Eric Anderson, Managing Director, SF Bay Area Sales and Local Tax practice, Andersen Tax; Andy Barton, Partner, Goodwin LLP; Bob Chung, Director of Valuations, Carta; Daniel Knappenberger, Silicon Valley Market Leader, Deloitte Advisory; Steve Liu, Head of Shareworks Valuation Services; Danny Wallace, Co-Leader of the Emerging Company Services Group, PWC.

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