What Every Founder Should Know About 409a Valuation
Equity is a tool that many startups utilize to gain capital and to offer to employees, but this is not as easy as it may seem.
When seeking out investors, the valuation of a startup is performed to determine the relative worth of a startup for an investor to understand what percentage of the company they should receive in return for providing their funding. While these valuations are important, they are not representative of the true value of a startup at the time of the deal.
Venture firms will have a valuation conducted that looks at the current status of a startup but also one that looks at the prospective value of the startup. This valuation also typically takes into account that the shares being given to an investor are preferred shares which give the shareholder more rights regarding payback if a business goes under. Traditional venture valuations do not constitute a 409a valuation.
When providing stock equity compensation to employees, it is important to note the key discrepancy between venture valuation and fair market value. This difference is the reason the 409a valuation exists today. Employees are typically given common stock and as such are worth less than preferred stock. Tax laws implemented the 409a valuation standard to allow for a baseline and unbiased assessment of the equity worth in a business that issues equity offerings to employees. With a fair market value attained by a 409a valuation, employees are able to appreciate the benefits of getting equity without fear of penalties.
As a founder, it is important to be familiar with the need for a 409a valuation to ensure the deferred payment of a startup’s stake is created without penalties. Giving equity to employees is a great way to compensate early employees’ dedication to a startup but it is important to stay within compliance to ensure these options are not penalized and a 409a valuation is how this can be achieved.
Below is everything a founder should know about a 409a valuation before attempting to create an effective team by utilizing equity compensation.
What is 409a?
409a is a regulation imposed by the IRC to have more control over non-qualified deferment compensation. Essentially the regulations are meant to ensure deferred compensation is fair and not easily manipulated. A lot of items are categorized as deferment compensation but the most pertinent to a founder is the distribution of equity in a startup.
When seeking out talent, a founder may want to tap into the equity holdings of the startup to incentivize individuals to join the startup. To do this and ensure the talent stays, a vesting schedule of some kind is often implemented where an employee does not have full ownership of the shares immediately but rather acquires them over time.
Since these shares are not an immediate form of compensation and are cashed out at a later date, this compensation becomes classified as a deferred payment option and falls under the regulations set by the 409a regulations.
These regulations need to be followed to ensure the harsh taxation penalties are not imposed. There are many different criteria that need to be met when offering a 409a applicable compensation and being aware of the different regulations as a founder can ensure that you are within compliance.
Why Do You Need a 409a Valuation?
A 409a valuation is an appraisal of the equity/shares of a company for the purposes of keeping a 409a safe harbor status. The valuation is an attempt to get an unbiased fair market value assessment of a business’s equity or shares.
With publicly traded companies, this can be attained by looking at an average of trade prices over time. With privately-held buConclusionsinesses, it becomes more difficult as a valuation needs to be conducted any time the fair market value needs to be determined. This is where the 409a valuation fits in.
Any time equity is being given out to employees in a startup, a 409a valuation is required.
While many small startups will most likely not be the target of an IRS audit, it is important to ensure as a founder that you are offering employees equity benefits without risking them having to face penalties due to being out of compliance.
Creating a habit of having at least annual 409a valuations conducted will be advantageous as the startup grows. As a startup grows, the IRS and government take notice and by having a long history of 409a valuations, it will better ensure that there will be no audit or question that the startup has been in compliance.
The main reason a 409a valuation is conducted is to avoid the penalties associated with being out of compliance and undervaluing equity. Being aware of the penalties can help gain a better understanding of why the valuation needs to be done when dealing with deferred compensation plans for employees. If a business is found to be undervaluing equity or stock, the IRS imposes penalties. This includes an immediate inclusion of the deferred compensation into the employees’ annual income statement making the initially tax-exempt deferment no longer valid.
Even if a vesting schedule has yet to run its course, the total amount is added to the individual’s federal income taxation. In addition, the deferred compensation amount is taxed at an additional 20% along with added interest penalties.
As a startup founder, it is incredibly important to understand the importance of a 409a valuation to ensure your valued employees will not have to undergo these harsh penalties. By a founder doing their part and ensuring the startup is in compliance, they can offer talent an amazing opportunity to have deferred compensation that grows in value alongside the growth of the startup.
How Often Does a 409a Valuation Need to Be Done?
A 409a valuation is an assessment and estimation of the fair market value (FMV) of a company share. Fair market value in the stock market is continuously changing and this is not something that is any different from private companies. Since FMV changes drastically and there are no stock markets to look at for privately owned businesses, startups and private businesses rely on valuations and more specifically 409s valuation to determine a strike price.
If the FMV is constantly changing then how often does a valuation need to be completed?
The answer depends on the relative rate of change that a startup undergoes. Generally speaking, to be considered under the 409a safe harbor a 409a valuation needs to be completed at least every year. This can be done internally following IRC requirements or it can be outsourced to an external team.
While 12 months is the minimum requirement to remain within the safe harbor, it is advised to get a 409a valuation done any time there is a large event within the startup. These can be either positive or negative changes but assuming a FMV based upon a previous valuation can be risky if a large spurt of growth happened in the time in between.
The main concern is the undervaluation of equity so it is advised to not offer equity at a price below the last 409a valuation performed. If the value of the last 409a valuation seems to be suspiciously low for the current state of a startup it is advised to get a valuation done to ensure the startup is safe from penalties.
How is a 409a Valuation Calculated?
When valuing a startup it can be incredibly difficult to come to a definite conclusion about the value a startup has. As discussed previously, a standard valuation will derive an answer to the worth of a startup but different valuations focus on different aspects.
Many valuations that are calculated for the purpose of seeking investors tend to have a larger value put on them because these valuations focus more on the potential of future value. These models look at comparative models, the promise of a new idea, the value of a dedicated and diverse team, and the future value of the product in the market.
The 409a valuation on the other hand looks at a startup based on where it is at the moment and evaluates the fair market value. The 409a valuation is conducted to give a company an idea of the fair market value of their equity to then transfer over to employees that opt for a deferred compensation plan.
Many startups look to outsource 409a valuations as the assessment is fairly complex, and having it done by an external business takes the liability off of the startup if the price calculated is later deemed to have been too low.
For startups that prefer to do a 409a valuation in house, it is important to stay as unbiased as possible and to report accurate data. The American Institute of Certified Public Accountants (AICPA) has a guide to valuing a private company for the purposes of finding the fair market value for the purposes of deferred compensation.
The guide breaks down all of the factors that can be taken into account with a 409a valuation. This includes the value of proprietary technology, strategic relationships, milestones reached relative to age, state of the economy, competition, and much more.
Ultimately a 409a valuation can be achieved through many different means and it takes skill and experience to correctly derive a FMV. Securing a 409a valuation from a third party and providing accurate data is the best way to ensure the startup remains protected against 409a penalties.
Why Was 409a Created?
The IRC 409a regulations were created to limit the abuse of deferred payment plans. In the early 2000s, the notorious Enron scandal occurred where many top-level executives prematurely cashed out deferred compensation before they were intended to file for bankruptcy.
The few executives that exercised their deferred compensation plans before bankruptcy cheated out many investors and lower-level employees within the corporation. These executives circumvented investors' preferred stock and stole money that would have otherwise been distributed in accordance with stock preferences and even common stock distribution. At the time, this was legal, and the 409a regulation was created to remove this from being able to occur.
409a is a blanket regulation that now applies to all non-qualified deferment compensations. Now there are strict guidelines as to how deferred compensation and valuations must be performed. These guidelines place limitations on deferment plans in that they are unable to run with as much autonomy as they once were.
While this may seem like too much red tape, it is in place to ensure a business and its employees are able to carry out deferred compensation plans successfully. Another added part of the reason 409a was created was to ensure deferment plans did not undervalue the equity or stocks. Undervaluing stakes in a business and then offering it to employees is fraudulent as employees are really receiving more than what is being recorded.
To dissuade this, 409a regulations state that undervaluation occurs the recipient must pay a 20% federal penalty plus any penalties. To protect a business from an IRS audit looking at the potential of undervaluation, a startup needs to have a 409a valuation performed annually to prove that their pricing was based upon fair market value.
Without a 409a valuation, it is much more likely that penalties will ensue if undervaluation comes to question.
In conclusion, 409a valuation is an integral part of the equity offering process.
Equity is a great way to attract talent to a startup but the rules and regulations surrounding equity need to be followed to a tee. The best way to ensure these regulations are taken care of is by getting a 409a valuation annually.
Third parties like Carta are a great means of getting a 409a valuation through an accredited appraiser. The valuation assesses the current state of a startup and determines the fair market value of the equity shares.
With this value, a startup is able to offer equity in a deferred compensation plan like a vesting schedule utilizing this price. As a founder, knowing what the 409a regulations are and how to navigate them is incredibly important especially when seeking out talent with equity.
With a solid knowledge of what 409a is and why a 409a valuation is needed, a founder is able to move past the regulations and ensure the startup succeeds.