How does an organization incentivize, retain, and reward key contributors? It’s a question asked by every business at some point. Salary increases and yearly cash bonuses are well-known rewards. Another common incentive is stock options (which can take various forms).
Cash awards are easy to value. But what are stock options worth? The IRS cares about the answer much as you do. That’s where a 409A valuation comes in.
What is a 409A Valuation?
A 409A valuation assigns a value to your company’s common stock. The IRS calls this “fair market value.” The fair market value is important because it sets the exercise price (also known as the strike price) for the stock option. In addition, the fair market value is important because it affects the amount of taxes that must be paid.
409A valuations are performed for private companies whose stock is not traded publicly (and thus do not have an observable market value).
Why Should I Care About a 409A Valuation?
You should care about a 409A valuation because the IRS cares. The IRS can perform its own assessment of the value of your company’s stock. If it determines that the fair market value was set too low, it will assess some major tax penalties on the stock option recipients.
You read that correctly. The individual recipients, not the company, are on the hook for any tax penalties. The penalties are steep: immediate taxation of vested awards at ordinary income rates, a 20% penalty, and interest.
409A valuations should be performed before the issuance of any stock options, and be refreshed periodically. A new valuation would be called for annually, or when a material event happens (e.g., a new round of funding is raised).
What Are Valuation Options?
There are 3 ways to perform a valuation:
- Do it yourself
- Use a software tool
- Hire a third party appraiser
Option #1 and #2 are cheap. But be aware that if the IRS challenges your valuation, the burden of proof is on you to show that it was reasonable.
Option #3 is the most expensive, usually running at a couple thousand dollars. But it is a safe harbor with the IRS. If you use a third party to perform the valuation, the burden of proof shifts from you to the IRS. Before penalties can be issued, the IRS must prove the valuation to be “grossly unreasonable.”
Carta’s web site has great primer on 409A valuation for more details.