In startups, offering equity compensation via a company stock (or token) incentive plan is part of attracting top talent.
Within that context, a 409a valuation:
- Is used to define a reasonable strike price for the equity compensation, and is typically issued by a neutral third party.
- Is needed to comply with IRS regulations regarding employee equity compensation. Do note that the 409a valuation applies specifically to stock options offered to US-based employees.
- Is part of ensuring that your company’s equity compensation falls under IRS safe harbor provisions (meaning the IRS considers your valuation to be “reasonable”) and that any federal income taxes are paid on deferred compensation plans, thus avoiding tax penalties and/or fines.
- Is valid for one year following the valuation date, or until a material event — a new fundraising round; a large, long-term contract; a significant shift in business model, etc. — impacts the company’s valuation.
- Is more of an art than a science, particularly in the company’s early stages. It can potentially be based on categories such as underlying assets, company income, or the company’s market. Thus a 409a valuation can consider key metrics such as company assets, the net present value of future cash flow, book values of comparable companies, control premiums, and more.
- Can also take into account company milestones, any proprietary IP, strategic partnerships, current investor base, and company management (among other possible criteria).
The takeaway: Having accurate 409a valuations is important so that your employees avoid any potential problems with the tax authorities. It’s also important so that your startup avoids any problems down the road, since any large investment and/or sale will bring with it scrutiny of the company’s 409a valuations and how they have been used within the equity compensation plan.
