A 409A valuation is an independent assessment of the fair market value (FMV) of a private company’s common stock. It is required by the Internal Revenue Code (IRC) Section 409A for private companies that issue stock options to their employees.

Why are 409A valuations important for startups?

There are several reasons why 409A valuations are important for startups:

• 409A valuation for compliance with IRS rules: The IRS’s Section 409A regulations were enacted to prevent companies from issuing stock options with exercise prices below the fair market value of the underlying stock. This is because such options would be considered non-qualified deferred compensation, and the IRS would tax the difference between the fair market value and the exercise price as ordinary income to the employee when the option is exercised. If a startup fails to comply with the 409A regulations, it can face significant tax penalties. The company itself can be penalized up to 25% of the excess value of the options, and the employees who receive the options can be penalized up to 20% of the excess value.

• 409A valuation for attracting and retaining top talent: Stock options are a valuable incentive for startups, as they allow employees to participate in the company’s future success. However, in order to be effective, stock options must be issued at a fair price. If the options are undervalued, employees may be less likely to accept them, or they may be disappointed if the stock price does not rise above the exercise price. A 409A valuation can help startups to ensure that they are offering their employees fair and competitive equity packages. This can help startups to attract and retain top talent, which is essential for their growth and success.

• 409A valuation and the halo effect of legal and regulatory compliance: A 409A valuation can create the halo effect in the minds of investors, instilling confidence in the company’s legal and regulatory compliance. This is because venture capital investors are always looking for ways to reduce their risk when investing in startups. One way they do this is by looking for startups that are compliant with all applicable laws and regulations. A 409A valuation can provide them with confidence that the startup is taking its legal and regulatory obligations seriously.

What are the risks of failing to get a 409A valuation?

• IRS penalties: As mentioned above, the IRS can impose significant penalties on startups that fail to comply with the 409A regulations.
• Employee lawsuits: Employees who receive undervalued stock options may sue the company for breach of fiduciary duty.
• Auditor scrutiny: Outside auditors may also second-guess a startup’s determination of the FMV of its stock options. If they conclude that the options have been undervalued, they may require the company to take a non-cash charge to earnings. This can reduce the company’s reported earnings and make it less attractive to investors.
• Reduced purchase price from acquirers: If a startup is acquired, the acquirer may second-guess the FMV determination of the company’s stock options. If the acquirer believes that the options have been undervalued, they may reduce the purchase price of the company or increase the amount of escrow held to cover potential claims.
• Increased SEC scrutiny: If a startup files for an IPO, the SEC is more likely to second-guess the FMV determination of the company’s stock options. If the SEC concludes that the options have been undervalued, they may require the company to take a non-cash charge to earnings and make additional disclosures in its IPO prospectus.

What are the benefits of obtaining a 409A valuation?

• Reduced risk of IRS penalties: As mentioned above, the IRS can impose significant penalties on startups that fail to comply with the 409A regulations. A 409A valuation can help startups to avoid these penalties by providing a credible and well-documented assessment of the fair market value of their stock options.
• Reduced risk of employee lawsuits: Employees who receive undervalued stock options may sue the company for breach of fiduciary duty. A 409A valuation can help to protect the company from these lawsuits by demonstrating that the board of directors took reasonable steps to determine the fair market value of the options.
• Increased auditor confidence: Outside auditors are responsible for ensuring that a company’s financial statements are accurate and reliable. A 409A valuation can help to increase auditor confidence in the company’s financial statements by providing independent verification of the fair market value of the stock options.
• Increased acquirer confidence: If a startup is considering being acquired, a 409A valuation can help to increase acquirer confidence in the company’s valuation. This can lead to a higher purchase price for the company.
• Increased investor confidence: If a startup is planning to raise capital in the future, a 409A valuation can help the company to accurately value itself and to negotiate favorable terms with investors.
• Reduced SEC scrutiny: If a startup is planning to file for an IPO, the SEC will carefully scrutinize the company’s financial statements. A 409A valuation can help to reduce SEC scrutiny by providing independent verification of the fair market value of the stock options.
• Attract and retain top talent: Stock options are a valuable incentive for startups, and a 409A valuation can help startups to ensure that they are offering their employees fair and competitive equity packages.

How can Eton help with 409A?

Eton Venture Services is a leading provider of 409A valuation services to startups. We have a team of experienced professionals who can help you to determine the fair market value of your company’s common stock in a way that is compliant with IRS regulations.

We can also help you to understand the benefits of obtaining a 409A valuation and to navigate the process of getting one done.

If you are a startup founder or CEO, we encourage you to contact Eton Venture Services today to learn more about our 409A fair market value valuation services. We can help you to ensure that you are complying with IRS rules, attracting and retaining top talent, and planning for future fundraising events.

Contact Eton today for a free consultation.