How does a 409A valuation affect your employees?

If you’re a founder trying to figure out how to set the price your employees should pay for shares of your company's common stock, you’ll need a 409A valuation. 

A 409A valuation is an assessment of the fair market value (FMV) of a private company’s common stock, done by an independent appraiser. This valuation is crucial because it determines the strike price, which is a set price at which a stock can be bought or sold. It is also the price at which you can offer stock options to your employees, which will only represent ownership interest when employees decide to exercise their options to acquire stock.

A 409a valuation is required when you intend to distribute equity in your company over a period of time. This is stipulated in section 409A of the Internal Revenue Code, which also contains the rules required to determine the FMV of your common stock.

It’s essential to ensure you’re getting an objectively accurate valuation because the strike price you land on has implications, particularly related to stock options, taxes and audits.

How a 409A valuation works

The 409A valuation process typically has three steps: 

1. Assessing your company’s worth

An appraiser will determine how much your company is worth, also known as its enterprise value. There are several methods the appraiser may use to conduct the valuation, including: 

• Income approach: this method calculates the present value of future profit streams the company is expected to generate. The appraiser will use financial projections and discount rates to determine the company’s value. The advantage of this method is that the company’s future expected profit influences it directly., The drawback is that it requires long-term validated forecasts.
• Market approach: this method compares the company to a set of recently acquired or publicly traded companies usually by industry which the appraiser will use to determine the appropriate valuation multiple (a ratio used to determine a company's value based on a specific financial metric).
  To make this comparison, the appraiser uses metrics such as EBITDA and revenue. The advantage of this method is that it reflects market conditions and is easy to understand. The drawback is it can be limited by the availability of data on comparable companies.
• Asset approach: this method uses the appraised value of all the company’s assets and liabilities. The advantage of this method is that it does not require any type of forecasting and can provide a large sample size of comparable data from similar assets. The drawback is that it can be expensive to appraise intangible assets such as intellectual property or goodwill.

2. Determining the Fair Market Value (FMV) of your company’s common stock

This is a complex process that typically involves various methods. Assuming that venture-backed companies have at least two equity classes (e.g., Series A/B/C/D/etc., preferred shares, and common shares), there are three methods- that appraisers can use to allocate the enterprise value across shared classes: the Current Value Method (CVM), the Option-Pricing Method (OPM), and the Probability-Weighted Expected Return Mmethod (PWERM).

3. Lowering the FMV using Discount for Lack of Marketability (DLOM)

The final step involves applying a discount for lack of marketability (DLOM) to the common stock value. This occurs due to the assumption that private companies do not have a public market to trade their shares, and their common stock are less valuable because of a “lack of marketability.” Your company’s DLOM can change depending on factors such as size, sector, and the degree of share liquidity. The DLOM can range from single digits to more than 50% of the stock's fair market value.

The IRS rules associated with the 409A valuation are laid out in U.S. Code § 409A. Public companies don’t have to worry about Section 409A because any stock options they offer employees will have a strike price equal to their stock’s FMV. But these rules can be more problematic for privately-held companies, like startups, since the strike price and the FMV are likely different.

How the strike price affects employees

IRS rules in Section 409A stipulate that if the strike price of a stock option is a fair market value on the date of issuance, then the stock option is treated as non-qualified deferred compensation—that is, compensation that an employee has earned but that they have not yet actually gotten from their employer. Under IRS rules, employees don’t have to pay taxes on deferred compensation until they actually receive the funds, and employers don’t have to worry about withholding on deferred payments. 

Section 409A puts strict regulations on how to ensure that stock options count as deferred compensation. If the 409A rules are not followed exactly, employees can find their options deemed taxable compensation instead of deferred compensation, leading to surprisingly large income tax bills they weren’t expecting.

Importantly, if the strike price is set too low for the IRS to agree that it reflects fair market value, then the agency may deem employees’ options to be taxable. This would give the employees tax obligations and the employer withholding obligations. 

How stock options are taxed

Stock options can be treated as either qualified stock options (QSO) or non-qualified tax options (NQSO) for tax purposes. Another name for qualified stock options is Incentive Stock Options, or ISO. The difference between these types of options is that profits made from QSO are taxed at the capital gain tax rate, which is typically below the option owners’ income tax rates. Gains from NQSOs, on the other hand, are taxed as income, which means they are usually taxed at a higher rate than QSOs. 

The advantage of NQSOs, despite the higher tax rates applied to them, is that they provide more flexibility regarding who can receive them and how they can be exercised. A recipient of NQSOs can immediately sell them, pocketing the difference between the market price of the option and the grant price—that is, the fair market value of the stock on the day it was granted. Meanwhile, a recipient of QSOs must hold them for at least one year before selling them. Companies, for their part, tend to like NQSOs better because the cost they incur for NQSOs can be deducted as an operating expense quicker than the cost of NSOs. 

Why to avoid in-house valuations

The need to avoid unexpected taxation is why it’s vital to get an objective and accurate estimation of the stock value under 409A. To help privately held companies cope with the difficulties of 409A, the IRS allows them to determine the FMV of their common shares in a way that the agency will accept, known as “safe harbor.”

Getting an accurate and objective judgment from a third party on your company’s valuation is the best way to ensure 409A safe harbor. Startups typically pay for these assessments, and there is now an entire industry of 409A valuation, with many firms offering these services. The cost of paying for a valuation by an outside firm is worthwhile, as it ensures that your company’s valuation will meet safe harbor standards and will withstand the scrutiny of an audit.

By contrast, quick valuations and those done in-house are high-risk and usually not defensible in an audit. The reason that the IRS is skeptical of in-house valuations is that there were cases of abuse in the past in which Boards artificially lowered the strike price to create attractive options to entice employees. The 409A rules were in part an effort to curtail such manipulations, so companies that continue to determine their own stock prices will receive much scrutiny and intense skepticism from the taxing agency.