Stock options allow employees to buy a piece of your company at a discount in exchange for their dedication and commitment. A 409A valuation helps ensure that your stock options are protected against IRS penalties. Let’s explore the basics of 409A valuations.

Employee Stock Options

Employee stock options are a type of equity-based compensation. According to the IRS, equity-based compensation is any compensation paid to an employee, director or independent contractor that’s based on the value of the specified stock (typically the employer’s stock). Employers that decide to offer equity-based compensation have several options, each of with comes with different tax rules, as well as pros and cons.

With stock options, employees generally receive the right to purchase a specified number of shares at a fixed “exercise price” for a predetermined period, usually subject to a vesting period. The IRS recognizes two versions — incentive stock options (ISOs) and nonqualified stock options. The latter offer greater flexibility because ISOs are subject to stricter IRS requirements.

409A: The Basics

The IRS requires private companies to issue options at a price that reflects the fair market value of the company’s shares according to regulations of the Internal Revenue Code. If the IRS audits your company’s financial records and finds that your company’s shares were not issued at fair market value, the IRS can impose substantial penalties, fines, and other sanctions, including taxes on the option recipients and additional taxes on the company itself.

However, there are benefits to performing this valuation service aside from IRS requirements. If your company is involved in a merger or acquisition, then a 409A valuation can be important in helping to determine the value of the company’s shares, and consequently, the value of the deal. Additionally, in regard to capital raising, investors often require a 409A valuation before investing in your company. A valid 409A valuation can provide assurance to investors that your company is following regulatory compliance and that the share options offered to employees have a fair and accurate exercise price.

Valuation Process

A 409A valuation is a three-part process in which a certified valuation analyst reviews your company information and current economy in order to understand the fair market value of your stock prices.

• Step 1: Determine the worth of the company (equity value)
• Step 2: The equity value is then allocated across the different equity classes to arrive at the fair market value for the company’s common stock.
• Step 3: Apply discounts to the fair market value, as appropriate, to account for the private nature of the company’s stock.

This procedure is required to be performed at least annually in order to recalculate the value based on company and economic changes over the period.

Some changes affect the value so greatly, they may necessitate a valuation before the annual valuation. These are called trigger events, as listed below:

• New equity financing
• Acquisition
• Significant changes to the Company’s financial outlook
• Secondary sales of common stock
• Approaching an IPO event

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