Few regulations are more annoying to early-stage entrepreneurs than IRC 409A. This regulation requires that stock options be issued with a strike price equal to or above the value of common stock.
This means that all startups — no matter how early the stage — must have a 409a valuation performed before issuing stock options to justify their choice of strike price.
That’s not all.
The risks of non-compliance with IRC 409A are severe. If found in violation, option holders must immediately pay taxes on all vested shares, an additional 20% penalty tax, and even interest on the unpaid taxes.
This is why private companies generally seek out a 409A valuation from an independent valuation services firm before issuing options.
The typical 409A valuation costs anywhere from $1,200 to $5,000+.
For startups in the earliest stages of development, this seems like a huge waste of time and money – time and money that could be spent growing the business.
So if your company has no revenue, no proven business model, and virtually no assets, should you pay someone to tell you what you already know (that your stock is worth very little)?
In this article, we explore that question and provide you with some pain-free ways to get a free 409a valuation for your startup.
Let’s get started.
Why does a company need a 409A valuation?
Now, let's learn a little more about the methodology behind this checklist. We'll start with why you need stock options in the first place.
Stock options have a strike price specifying the price at which stock may be purchased if the option is exercised. IRS regulations require you to set the value of the strike price equal to the fair market value (FMV) of your company’s common stock or face some awful tax consequences.
Most people use the term 409A compliance to refer to compliance with two sections of IRS law: IRC 409A and IRC 422. There is some confusion among entrepreneurs about the difference. In short, IRC 409A relates to NSO stock options and IRC 422 relates to ISO stock options.
But in both cases, you must issue your stock options at the FMV of your common stock. In fact, any ISO options NOT issued at the FMV automatically become NSO options and then fall under the jurisdiction of IRC 409A.
So what are your options for complying with 409A?
Basically, you need to either pay for a valuation or perform one yourself.
The valuation serves as evidence that you are not arbitrarily setting a ridiculously low strike price on your options, but are indeed setting them equal to the FMV of your common stock.
What is the right 409A solution for my company?
Choosing a 409A solution is a lot like choosing an insurance product. Your decision depends on your risk tolerance and how much you are willing to spend to decrease your risk.
To understand the risk, you need to understand:
- the standards the IRS has set for compliance
- the potential of being audited,
- the likelihood of failing an audit, and
- the penalties of non-compliance.
IRS compliance standards and 409A valuation safe harbors
The IRS has offered some general standards for compliance.
IRC 422 requires companies to make a “good faith” effort to value their stock. If “there is a failure in [the] attempt,” as long as the company made a “good faith” effort, the requirement shall be considered to have been met.
IRC 409A specifies that a valuation meeting certain defined criteria will put a company in “safe-harbor.”
Safe-harbor is a very important legal term when considering 409A valuation options. If a valuation qualifies for safe-harbor, then the burden of proof shifts to the IRS.
Having safe-harbor basically means two things:
- You do not have to prove that your valuation is correct.
- If the IRS has an issue with your valuation, the IRS must prove that your valuation was “grossly unreasonable.”
This provides enormous protection when it comes to audit and tax risk. Proving something is “grossly unreasonable” is very difficult, especially if you have taken some basic precautions.
So what qualifies a valuation to achieve safe harbor? The following conditions must be met:
- The valuation must be performed by “qualified individual(s)” or by an independent appraiser.
- The valuation must be performed within the last 12 months.
- The valuation must be evidenced with a written report.
“Qualified individuals” includes anybody with a set of experiences that would allow a company to reasonably rely on their valuation work. The IRS doesn’t give much more information about “qualified individuals,” but industry commentators have often included the following individuals in the qualified group:
- Directors or board members with significant financial, investing or valuation expertise
- CFOs with valuation knowledge
- Angel investors or venture capitalists
- Investment bankers or private equity professionals
- Valuation professionals
Because of the ambiguity in the definition of “qualified individuals” and because performing a 409A requires certain technical expertise (notably allocating a company’s value among various classes of stock), many industry commentators feel that trained and experienced valuation professionals are the only safe option.
If a valuation meets certain “safe-harbor” standards, the IRS must prove that the analysis is “grossly unreasonable” in order to enforce any kind of penalty.
Here’s the kicker:
If a valuation is not under safe harbor and the IRS challenges the valuation, then the company must prove to the IRS that their analysis is sound and accurate to avoid penalties.
Since IRC 422 only requires a “good faith” estimate, it may be that the IRS doesn’t expect companies granting ISOs to get a full-blown safe-harbor valuation from a valuation services firm.
On the other hand:
Since it isn’t immediately clear what constitutes a “good faith” estimate, most companies that can afford it choose to still get the standard 409A valuation as this certainly qualifies as “good faith.”
The potential for an IRS audit and the likelihood of failing
Many industry commentators have pointed out that the IRS has never brought an enforcement action against a company for a 422/409A violation in over 10+ years.
But in our experience, it is never wise to flippantly dismiss any IRS-related risk.
The IRS has recently requested some information from about 50 companies to see if they would like to become more active in 409A compliance.
Ultimately, we feel that the risk of an audit is very low for a startup company that takes some very basic steps, such as using an online calculator and asking a few financial experts to review the results.
Valuing a private company is notoriously difficult and subjective. We believe it would be difficult for the IRS to definitively prove an incorrect valuation. So they would have to focus on a lack of effort.
The penalties of non-compliance
We recently published an article that addresses this: Just How Bad Is 409A Non-Compliance for a Startup, Really?
The punchline is that 409A non-compliance could be really painful and you definitely want to avoid it.
Making a decision
In essence, there are three types of 422 / 409A valuations you could consider (from highest to lowest risk):
- Valuations you perform by yourself
- Valuations performed by a qualified individual (depending on the individual, this may meet the safe-harbor and good faith tests)
- Valuations performed by a qualified, independent appraiser or valuation services firm (meets safe-harbor and good faith tests)
The cost of these valuations increases as you move from the higher-risk options to the lower-risk options.
Unless you happen to be a “qualified [valuation] individual”, option 1 will not meet a safe-harbor test but could meet a “good faith” test provided you used some software.
If you prefer a lower risk valuation, you’ll want to hire an independent valuation services firm. You can do this at a low cost with a 409A subscription through startup edition. Some firms will charge you between $3,000 and- $5,000+ per valuation.
Ultimately, you need to decide the likelihood of a challenge by the IRS, and whether or not you would feel comfortable defending your valuation to the IRS. For very early-stage startups, the risk of any IRS involvement is low.
Am I a candidate for a free 409A?
Shareworks Startup Edition's bright-line recommendation is that you should only consider using a free 409A Calculator, if your company meets the 7 DIY Valuation Criteria mentioned in the first paragraph of this article.
If you do, a free 409A could be a great option for you, especially if you want to trade a bit more risk to save a couple thousand dollars.
Some argue that you get what you pay for when it comes to quality and customer service, but 409A valuations for startups have been largely standardized and commoditized.
The methodology and need for quality definitely change as companies mature, but that doesn’t mean you need to spend a lot of money for a quality valuation when you are first getting started.