How to Obtain a 409a Valuation For Your Company And When To Do It

Posted byJames GravesPosted inUncategorized

This post will cover the best way for your company to obtain a 409a valuation, the reason why, and when your company needs to obtain one. 

If you’ve ever started a company, you know and are probably sick of dealing with the terms “fair market value” (FMV) and “409a”.  There is already tons of educational content from the legal community on what Section 409a is, why it is important, and its minutiae.  I am sure you are sick of reading about the rules by now.  Rather than conceptually rehash Section 409a, what I will try to do in this post specifically is set forth the best way to obtain a 409a valuation, why, and when your company needs to obtain one. 

The Best Way to Undergo a 409a Valuation

The Independent Appraisal Method

The best way to undergo a 409a valuation is via an independent, professional appraisal of the company’s FMV done by companies like Carta or Scalar, called the “Independent Appraisal” method.*  Why? Because the law gives the professional appraisal of the FMV of a company’s stock a rebuttable presumption of reasonableness.  This means that if the IRS ever audited the company, the burden of proof would be on the IRS, not the company, to show that the methodology used was not a  “reasonable valuation methodology.”  This dramatically reduces the likelihood of a successful IRS challenge of FMV.  

May the value of your common stock rise as high as this giraffe’s neck.

Be Careful Doing It By Yourself

Compare this to if the company used a different method of appraisal, such as doing it by itself.  In this case, the burden of proof would be on the company to demonstrate it used a reasonable valuation methodology.  This is expensive, time-consuming, and highly burdensome to prove.  Even if the company was 100% correct, it would take time and money the company could otherwise invest elsewhere to meet its burden of proof.

Further, the company runs the steep risk that it simply did not use a reasonable valuation methodology.  You are in the business of running your company, not valuing shares of stock.  You are therefore by definition probably not qualified to do so.  Why run the risk, when the adverse consequences are so dire? 

My one caveat here is this.  If you are a brand new company, say, less than a year old, you probably can rely on a good-faith valuation of your shares that you do yourself since the shares’ value would be so nominal.  However, as you grow, start considering an Independent Appraisal sooner rather than later. 

Your Employees May Be Penalized By The IRS The Most For Your Non-Compliance

What’s more, the tax penalties for violating Section 409a are not imposed on the company.  They are imposed on the company’s service providers (e.g., employees or independent contractors) unless the company fails to report or withhold any amount that becomes taxable because of a failure to comply with Section 409a.  These penalties include: 

  • All vested deferred compensation (e.g., options or restricted stock) becomes taxable immediately.
  • An additional 20% penalty tax levied on the service provider on top of regular income tax.
  • Possible imposition of interest on previous years’ vested equity compensation. 
Drawing parallels between these stock images and the content of blog posts is honestly more difficult than my law practice.

When Your Company Needs to Obtain a 409a Valuation

First, an Independent Appraisal valuation only lasts twelve months. So, your company should plan on obtaining one at least annually if it wants to have the ability to consistently issue deferred equity compensation in compliance with Section 409a. 

Second, the valuation via Independent Appraisal only lasts twelve months if an event that “materially affects the value of the corporation” has not occurred in the interim.  Here are some examples of material events that could re-trigger the company’s obligation to undergo another 409a valuation: 

  • The resolution of material litigation (explicitly mentioned in the regulations)
  • The issuance of a patent (explicitly mentioned in the regulations)
  • A debt or equity financing
  • Undergoing any sort of merger or acquisition 
  • Launching a central product or service of the company.  

Note that this is a non-exhaustive list, but should give you a good idea of what would be considered a material event. 

Finally, the entire 409a valuation process typically takes around two weeks to complete if you are organized and have all your documents ready to go.  However, most startups aren’t, which can extend the process to a month, or even longer.  Waiting for a 409a can hold up equity grants, which can have a negative ripple effect on your organization.  So, be sure you are organized and current and ready for the valuation process.  

Conclusion

In sum, Section 409a is a very complex statute and this post is just the tip of the iceberg. Always consult with an attorney if you have any questions and always feel free to contact me. 

By: James Graves

Disclaimer: this post is for informational and educational purposes only.  It is not intended to provide any legal advice.

* Note that there are two more “safe harbor” methods set forth in Section 409a called the “Formula Valuation” and “Start-up Company Valuation” methods.  While valid, these are more difficult to comply with and I do not praise them as highly as the Independent Appraisal method.