When is the right time to get a 409a?
The right time to get a 409a valuation depends on events at your startup—such as fundraising, or hiring employees paid with equity.
If you get a 409a valuation too early, you expend scarce early-stage capital on a service that will likely create unnecessary inconvenience. Get a 409a too late, and you risk selling underpriced options—which can net you serious fines from the IRS.
Here’s how to tell when it’s time to get a 409a valuation. But first, a crash course on what a 409a is, and why companies need them.
What is a 409a valuation?
Typically, upon forming, a new startup will divide common stock among its founders at a low, provisional price. In Capbase, the default is 10 million shares at $0.00001 per share.
Later on, as your company grows—developing assets like intellectual property, accruing value through the investment of time and energy—that $0.00001 is too low to serve as a Fair Market Value (FMV).
If you were to give additional stock to founders at that valuation, or make it a part of your employee stock option plan, you’d be selling underpriced stock. And it’s no good setting a new fair market value based on what you think it would be worth; there’s nothing to stop you from undervaluing the stock.
Our full article on 409a valuations explains why that’s a bad thing, and why the IRS doesn’t want it to happen. Suffice it to say, the IRS has put in place controls to prevent companies from selling stock below fair market value. Namely, they require you to hire an outside authority to assign a realistic value to your company and its stock.
When you get a 409a valuation, you hire a firm the IRS considers to be trustworthy to evaluate your company. It costs you money, and it reduces the amount of tax the IRS could collect from you. But it makes accountants happy, and it’s part of the dance you do when you build a startup.
How do you know you need a 409a valuation?
There are two occasions when you must get a 409a valuation:
- When you start planning stock options
- When your company undergoes a material event
Here’s a rundown of each.
Here's a rundown of each:
Getting a 409a when you start planning stock options
Your company is new, you have brilliant co-founders with brilliant ideas, and you’re ready to start building. Problem is, you don’t have a lot of spare cash for hiring talent.
Not to worry. Offering stock options attracts employees to your startup and incentivizes them to help you succeed long-term.
However, if you set up your new employee with a stock option plan, and the strike price is lower than what the IRS later deems acceptable, they could get dinged.
At minimum, they’d be forced to pay a 20% penalty on their valuation. That’s on top of any taxes owed on the difference between the strike price they paid and what is later deemed an appropriate fair market value.
When you start planning to hire a workforce and partially compensate them with stock options, it’s time to get a 409a valuation. Doing so now will save you—and your employees—headaches later on.
Getting a 409a when your company undergoes a material event
In this case, a “material event” is anything that changes the value of your company. That includes:
- A qualified financing round (you sell common shares, preferred stock, or convertible debt to outside investors)
- A merger with another company
- Acquisition of another company
- Acquisition by another company
- Secondary sales of common stock
- Major changes to your business model or financial projections
It’s important to get a 409a after any one of these material events, but especially after a qualified financing round. Once investors have funded your company, its value has changed.
Bonus 409a trigger! The one year expiry date
One more thing: after you get a 409a valuation, it’s good for 12 months after the valuation date.
Meaning, every 409a valuation is good for a year. Mark it on your calendar now: just because you’ve done a 409a doesn’t mean you’re in the clear.
If you plan on issuing more common stock, you’ll need to get another valuation. If your company hasn’t undergone any material changes, you may go past the 12 month mark—meaning, your previous 409a has effectively expired—but, at this point, you’re leaving 409a safe harbor (covered below).
Your safest bet is to get a new 409a after 12 months have elapsed, or after a material event—whichever comes first.
Should I get a 409a valuation the moment I form my startup?
In a word, no. When you first form your company and distribute common shares to founders, there’s no need to get a 409a valuation. It’s only necessary to get a 409a after your first priced round.
What about 409a safe harbor?
You may have heard of 409a safe harbors. IRC 409a explains three situations when your company is in the clear, and you don’t have to worry about the IRS coming after you because you sell in-the-money options or stock.
- Binding formula safe harbor. This one is rarely used. By applying a standard formula when transferring stock, you can ensure you stay in the clear with the IRS. Because the formula is complex, and so are the rules about how you can use it, startups don’t often go this route.
- The illiquid startup safe harbor. If you don’t anticipate an IPO within the next 180 days, or a change of control (ie. acquisition) within the next 90 days, you can have your 409a valuation handled by a qualified individual—basically, an accountant who knows what they’re doing.
- The independent appraisal safe harbor. As long as you hire a reputable outside firm that consistently applies and documents their methodology while appraising startups, you’re in the clear. This is the option most startups go with.
How much does an independent 409a valuation cost?
Hiring an outside firm to complete your valuation will cost you $1,000 to $10,000, depending on a variety of factors—like how many shareholders you have and the classes of shares, as well as your overall business model and financial structure.
Some cap table and incorporation tools used by startups offer 409a valuation as part of their services. It’s outside the scope of this article to determine whether those are trustworthy, or whether they put you at risk of scrutiny from the IRS.
We’ve partnered with Economics Partners and a number of other firms to provide Capbase users with 409a valuations. When you work with these firms, you can be sure to achieve independent appraisal safe harbor. Be sure to ask about your 409a valuation if you are signing up for Capbase.
Has the time come? Are you ready to get a 409a valuation for your company ASAP? Your comprehensive guide to 409a valuations walks you through the process.
Written by Bryce Warnes
Bryce Warnes is West Coast based writer specializing in fintech and entrepreneurship.