What Is a 409A Valuation? A Guide for Startup Founders

You’ve jumped through the hoops of starting a company, managed to raise some capital, and now you're trying to issue stock options to your employees.

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Your first thought is to just get this done, but let’s think about what you are actually trying to accomplish. As a start-up founder, your goal is to attract the best employees to help realize your vision and in order to get the best and brightest employees you need to issue equity in your company to those candidates.

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When issuing equity compensation, you need to keep IRC 409A in mind. The Internal Revenue Service created the tax code IRC 409A in 2004. If you don’t stay in compliance with Section 409A, you could face penalties and interest. Let’s take a quick look at what you need to do and why.

What is a 409A valuation?

A 409A valuation is an independent appraisal of the value of your company’s common stock. A 409A Valuation sets out to determine the fair market value (FMV) of a company’s stock. It helps estimate the value on the date of grant.

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Please find a direct link to the tax code here Internal Revenue Section 409A, which was added to the Internal Revenue Code as part of the American Jobs Creation Act of 2004.

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Passed in part as a response to the Enron accounting scandal of 2001, IRC 409A closed some loopholes on how stock options are taxed. It’s primary impact on your business is that it prohibits stock options from being considered as tax-deferred compensation unless the option strike price equals the current value of the stock.

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Is a 409A valuation required for an early-stage startup?

Yes, if you are issuing options to employees, you will need a 409A. By utilizing an expert solution, what you are really getting with a 409A is Safe Harbor against the IRS penalties and interest. There are different methods to go about obtaining safe harbor status—the most common method is to work with a qualified, independent, third-party appraiser on your 409A valuation.

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Additionally, when you go to raise the next round, most sophisticated investors will want to be sure all of your previous options are in compliance with Section 409A, to make sure you have been running your company with an optimal level of corporate governance.

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How often do I need to complete a 409A valuation?

Best practice is to issue an updated 409A when there is a material event or at least every 12 months. Examples of material events that would impact the 409A are new fundraisings, major technical breakthroughs, significant changes to the financial forecasts, significant changes to key personnel, and more.

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That means you should expect to go through the 409A process again after the first 12 months, and again after that.

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Should I use a Cap Table provided 409A?

While sometimes appropriate as we discussed at the start, cap table providers are not focused on valuation and the point of this exercise is to get to the most optimized price to incentivize your employees. We believe valuation-specific providers, such as initio, can help get better outcomes for companies based on understanding your specific vertical, funding history, and cap structure.

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How is my company’s 409A valuation calculated?

While the methodologies are consistent between providers, picking the proper inputs and comparable public and private companies can make the difference in your final 409A outcome.

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Utilizing a provider without the necessary expertise can come up to values that are deeply suboptimal depending on the selection and application of inputs.

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What are the benefits of an optimized 409A valuation?

You will be giving more upside to your employees, which makes your company more attractive as an employer. Additionally, beware of the free 409A offerings by cap table providers. While they may save you a few dollars in cost, the increase in indicated value will cost your employees tens to hundreds of thousands or more only to save you $2,500 today. Not a good business decision at all.

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Next steps

Initio offers the only fully automated 409A solution that shows you the entire defensible range of values to help you pick the final number that is right for you and your company. Setup takes less than 15 minutes, and you will have your report within 7 business days. If you have a problem with setup, we have live people that you can call and get help. If you already used your cap table provider to get a 409A, sign up risk free—our system can get you to a better defensible outcome, guaranteed.