409A Valuation

How a 409A valuation works

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation. A stock option granted with an exercise price below the fair market value of the underlying stock on the grant date is treated as deferred compensation and falls inside those rules, which an ordinary option cannot satisfy. A 409A valuation exists to prove that the grant did not have a discounted strike price.

The rule the whole exercise serves is one line:

Option exercise price ≥ fair market value of one share of common stock on the date of grant

Fair market value of common stock is not the price a venture investor just paid. Investors buy preferred stock, which carries a liquidation preference, protective provisions, board rights, registration rights, and often participation or dividend rights. Common stock has none of that, and it has no market to sell into. A valuation firm builds an enterprise value, most often using a market approach against comparable public companies or transactions, an income approach, or a backsolve from the most recent financing, then allocates that value across the share classes and applies a discount for lack of marketability to the common.

The allocation step is where most of the spread comes from. Practitioners generally use one of three methods described in the AICPA's practice aid on valuing privately held company equity securities issued as compensation: the option pricing method, which treats each share class as a call option on enterprise value; the probability weighted expected return method, which values the common across modeled exit scenarios; and the current value method, which is only appropriate at the very ends of a company's life.

Section 409A's regulations do not require any of this. What they do is create presumptions. Under the final regulations, a valuation made by one of the specified methods is presumed to be fair market value, and the IRS can rebut it only by showing the valuation was grossly unreasonable. The regulations set out three such presumptions for private company stock:

• An independent appraisal.
• A generally applicable repurchase formula that would be treated as fair market value under Section 83, applied consistently for compensatory and noncompensatory purposes.
• For illiquid start-up stock, a written valuation by a qualified individual, made at a time when the company did not otherwise anticipate a change in control or a public offering.

That last one has a hard edge. The start-up presumption does not apply if, at the time of the valuation, the company or the option holder may reasonably anticipate a change in control within the next 90 days or an initial public offering within the next 180 days.

Without a presumption, the burden flips. The company has to show the price was reasonable, and if it cannot, the option holder is the one who pays: the discounted amount is included in income, and Section 409A imposes an additional 20 percent federal tax plus interest on top of ordinary tax. Some states add their own penalty.

The refresh convention follows from the independent appraisal presumption, which is tied to a valuation made within the twelve months preceding the grant. In practice boards refresh annually, and sooner after any material event, most obviously a priced financing round, but also a large acquisition, a change in forecast, a secondary sale of common stock at a known price, or a decision to pursue a sale.

Worked example

Suppose a company closes a Series B at 4.00 dollars per share for preferred stock, selling 10 million shares for 40 million dollars. All figures here are hypothetical.

Step one, establish total equity value. Backsolving from the round, the appraiser derives an equity value that makes the Series B worth exactly what the investors paid on the allocation model chosen.

Step two, allocate across classes. The option pricing method assigns value to each class based on where it sits in the payout stack. The Series B holds a 1x non-participating preference of 40 million dollars and sits senior to the Series A, which sits senior to common. Below an exit of roughly 40 million dollars, the common receives nothing, so the common's value comes entirely from outcomes above the preference stack.

Step three, apply a marketability discount. The appraiser applies a discount for lack of marketability, reflecting that no holder of common can sell. Suppose the concluded discount is 30 percent.

Step four, conclude. The appraiser concludes fair market value of the common at 1.36 dollars per share, 34 percent of the preferred price.

Step five, set the strike. The board adopts 1.36 dollars as fair market value by written consent, and every option granted from that date until the next valuation or material event carries a strike of at least 1.36 dollars.

Step six, what happens if the board had used 0.50 dollars instead. On a grant of 40,000 vested options, the discount is 0.86 dollars per share, or 34,400 dollars of income to the employee in the year of vesting, plus an additional 20 percent tax of 6,880 dollars, plus interest. The employee owes this whether or not they exercised or sold anything.

Where it shows up

The valuation report itself is the primary artifact. It states the valuation date, the methods used, the concluded per-share value of common, and the appraiser's qualifications, and it is what the company produces if the price is ever questioned.

The board consent is the operative document. A valuation is a recommendation until the board determines fair market value and records that determination, and every option grant approved afterwards references it.

The stock option grant notice and the stock plan carry the exercise price forward to the option holder. The plan typically requires that the exercise price be no less than fair market value on the grant date, which is also a condition of incentive stock option treatment under Section 422.

Rule 701 disclosure obligations attach to the same grants. A private company relying on Rule 701 to issue compensatory securities must, above a dollar threshold in a twelve-month period, deliver financial statements and risk disclosure to recipients.

If the company files to go public, the same history appears in the registration statement. The SEC reviews the gap between historical option strike prices and the IPO price, a review long known as the cheap stock analysis, and comment letters on that subject are public on EDGAR.

Common mistakes

• Granting options between a signed term sheet and a closed round on a stale valuation. A priced round is a material event, and the start-up presumption is unavailable once an IPO is reasonably anticipated within 180 days or a change in control within 90 days.
• Promising a hire options at an offer-letter date and actually granting them months later. The grant date controls, and the price may have moved.
• Treating the valuation as a target to be negotiated. The appraiser's independence is what creates the presumption; pressure on the conclusion destroys the thing being bought.
• Letting a report age past twelve months. The independent appraisal presumption is tied to a valuation within the preceding twelve months.
• Ignoring secondary sales of common stock. A tender offer or a founder selling shares establishes an observable price for common, and appraisers weigh it.
• Assuming a low strike price is unambiguously good for employees. It lowers the cost to exercise, but a strike set below true fair market value shifts a 20 percent penalty plus interest onto the employee, and the incentive stock option status of the grant can be lost as well.
• Confusing the 409A value with what the company is worth. One measures common stock with no preference and no market; the other is the preferred price a specific investor paid for a specific set of rights.

Related terms

A 409A valuation sets the exercise price for grants made out of the option pool, and those grants are subject to vesting before anyone can exercise. The valuation's starting point is usually the price of preferred stock from the most recent round, so it moves with the post-money valuation and is shaped by the liquidation preference stack negotiated in the term sheet. The resulting strike prices live on the cap table.

Frequently asked questions

What is a 409A valuation?

It is an independent appraisal of the fair market value of a private company's common stock, used by the board to set the exercise price of employee stock options so that the options are not treated as discounted deferred compensation under Section 409A of the Internal Revenue Code.

How often do you need a 409A valuation?

At least every twelve months, and again after any material event. The independent appraisal presumption in the Section 409A regulations applies to a valuation made within the twelve months preceding the grant, and a priced financing round, a significant acquisition, a meaningful change in forecast, or a decision to pursue a sale all reset the clock.

What happens if a company gets the 409A wrong?

The option holder bears the consequence. The discount is included in income, and Section 409A imposes an additional 20 percent federal tax plus interest on top of ordinary income tax. The company faces withholding and reporting exposure, and the problem usually surfaces in diligence for a financing or an IPO, at the least convenient moment.

Why is the 409A value lower than the price investors just paid?

Investors buy preferred stock with a liquidation preference and other rights, and employees receive common stock with none of them and no way to sell. The appraiser allocates enterprise value across the classes, so the common absorbs only the value above the preference stack, then applies a discount for lack of marketability.

Who can perform a 409A valuation?

For the independent appraisal presumption, a qualified independent appraiser. The illiquid start-up presumption instead allows a written valuation by a qualified individual, subject to the conditions in the regulations, including that neither a change in control within 90 days nor an IPO within 180 days is reasonably anticipated. Boards generally use an outside firm because the presumption is the point.

Does a 409A valuation affect the company's fundraising valuation?

No. They are separate determinations of different things. A financing price is negotiated for preferred stock with a defined set of rights; a 409A conclusion is an appraiser's view of common stock for tax purposes. Investors do not price rounds off the 409A report.