409A Valuation

409A Valuations are an essential part of a startup founder’s / owner’s / management’s equity toolbox. But what exactly are they, what purpose do they serve, and when / how should one consider using them?

Before we get into all that, we should talk about where 409A Valuations come from, and it’s–you guessed it–Section 409A of the US Internal Revenue Code (“IRC”), or what we colloquially call, in the US, the “tax code.” Section 409A imposes certain tax liabilities on certain types of nonqualified deferred compensation, but (and most importantly, for our purposes), it does not apply to both incentive stock options (“ISOs”) and non-qualified stock options (“NQSOs”) granted at fair market value.

With that context, the connection between the valuation of a company’s equity and Section 409A of the IRC should start to become clear. If a company can avoid the tax liabilities imposed by Section 409A so long as it grants ISOs and NQSOs at fair market value, it’s simple to understand why it’s important to know what the fair market value of the equity is at time of granting such ISOs and/or NQSOs. And, of course, the process of determining the fair market value of any asset, such as a company’s equity, is the performance of a valuation.

So, now that we know what a 409A Valuation is, and what function it serves, the next questions are when and how should they be used / performed? These are questions that startup founders / management teams should pose to their startup lawyers and tax professionals.

In terms of timing, it’s crucial to establish the fair market value of equity prior to issuing ISOs or NQSOs on such equity. So, at a minimum, such valuations should occur prior to such grants. However, there are other times when performing a 409A Valuation will likely be appropriate. Such times may be event-driven, such as after raising a round of financing, or when there’s another material event that impacts the value of the underlying equity of the company. Nonetheless, a 409A Valuation can be performed on an annual basis as a matter of corporate practice. A startup attorney with knowledge of a startup’s business model and operations should be well positioned to offer advice on the company’s plan for 409A Valuations.

In terms of the “how,” there are two distinct approaches to performing a 409A Valuation: internal and external.

Internal valuations are performed by a company’s Board of Directors, or a committee thereof at the direction of and with the approval of such Board. These valuations are performed using standard methodologies and accounting rules, and upon a challenge from the Internal Revenue Service (“IRS”), the burden will fall on the company to justify the reasonability of the internal valuation.

External valuations are performed by a third-party accounting or financial services firm. The methodologies and accounting rules applied are nevertheless standard and / or generally accepted under professional standards. External / third-party valuations, of course, come with an associated cost for the performance of such valuation. However, unlike with respect to internal valuations, external / third-party valuations are given the benefit of the doubt, and, when challenged by the IRS, the burden shifts to the IRS to prove why such valuation is grossly unreasonable. This “presumption of reasonability” comes with two caveats: 1) it was performed within 12 months of the date of the applicable option grant; and 2) no material change to the company’s value has occurred between the date of the valuation and the date of the applicable option grant.