A 409a valuation gets its name from Section 409A of the Internal Revenue Code (IRC), which the IRS added to the American Jobs Creation Act in 2005, thanks to Enron’s shady dealings before folding.
Hopefully, we all learned a thing or two from this fallen energy company. Still, just in case, the IRS clearly lays out important tax regulations, rules, and timelines by which a company can value its shares and compensate employees tax-free.
Without going too deeply into tax code and the full nuances of Section 409A, this blog will give you a basic overview of what a 409 valuation is, why startups and private companies need one, and how to get one. Keep reading if you’re a startup founder, board member, or even an employee.
What Is A 409a Valuation?
A 409a valuation establishes the fair marketing value (FMV) of your company's common stock. The company's valuation then allows you to set your strike price, also known as the exercise price. This is the price at which the owner of a stock option can sell or buy a given number of shares. With your FMV and 409a valuation report in hand, you’ll set the strike price equal to or above the FMV.
What a 409a Valuation is NOT
- Equivalent to the valuation you just raised money on
- Equivalent to what you want to raise money one
What is it used for?
With a 409a valuation, your leadership team has an alternative way to compensate employees without using up vital early stage funds by offering option grants. An option grant is a right to acquire a set number of shares of a company's stock at a set price, which you’ve already determined as your strike price. Employees then have the right to buy these shares at a pre-determined future grant date. The 409a valuation ensures that you do not offer options to your employees below your fair market value.
It’s worth noting that offering employees stock options has become an increasingly common way to incentivize recruits and stand out among the crowd, especially when the job market favors the job seeker. Stock options also give employees a sense of ownership in their work and encourage longevity with your company.
When should you get one, and how often?
Most financial experts highly recommend that any private company get a 401a valuation early on. Still, there are key moments in the life of a startup where you’ll want to act immediately to put this in place. Consider getting a 401a valuation if:
- You want to start offering stock options to your employees as alternative compensation.
- You raised or are in the process of raising new funding or nearing IPO. An up-to-date valuation can help attract new investors.
Once set, a valuation is good for 12 months or until a major or “material” event impacts your company. A material event could be anything from changing business models to raising more funding, the most common of which is the latter.
Are they public?
A simple question and response, but one we find often asked. The good news is that until you are a publicly-traded company, you can keep your startup's financials private to the public.
How do you get a 409a valuation?
There are two ways to go about the 409a valuation process — either do the valuation yourself or work with an outside appraisal firm.
While doing it yourself could save you some money upfront, and financials at an early stage startup may not seem too daunting, the benefits of hiring an appraiser outweigh it all. Here’s why:
1. Compiling Financial Statements — To determine a 401a valuation, a company must compile several financial statements. Gathering all this information can be a burden on a small startup unless the proper reporting systems are already in place. In addition to industry market data, some key internal financials needed are:
- A P&L statement (profit & loss)
- Recent funding or a cap on a convertible note or SAFE
- Income sheets
- Your cost to recreate (what would it financially take for you to rebuild your company from ground zero).
2. IRS Protection — A professional can give you the peace of mind of a more robust and accurate valuation and thus help you provide better value to your employees. Most importantly, only a professional can guarantee you 409a Safe Harbor should the IRS audit your company. Outside of Safe Harbor, you have the “burden of proof,” which means the IRS can assess penalties on your company and shareholders for not following the rules.
See Also: 5 Tips To Improve Financial Management For Startups
What does the 409a valuation process cost?
409a valuations typically start around $1,000 but can soar upwards of $10,000 for large corporations. Overall, cost equates to company size, startup stage, and the complexity of the startup’s financials. When using an independent appraiser or valuation firm, prices will also vary between providers.
How Zeni Helps Prepare Startups For A 409a Valuations
Zeni is a full-service financial firm that provides bookkeeping, accounting, and CFO services for startups. We keep our startups ready at a moment’s notice for any type of valuation or report to investors by using artificial intelligence and machine learning to accurately complete your bookkeeping daily. Should your startup be ready for a 409a valuation, you can get started immediately with up-to-date books and financial records at the ready— and a dedicated Zeni professional on your team.
Interested in exploring Zeni’s advanced bookkeeping capabilities for your business? Book a demo to learn more about Zeni’s financial services and dashboard today.