409A: Everything You Need To Know for Your Business

In the world of early-stage companies, equity compensation is a valuable incentive to attract, hire, and retain top talent. IRC Section 409A, which went into effect in 2009, provides a framework for privately held companies to grant equity compensation. An important part of complying with IRC Section 409A is obtaining an independent business valuation to estimate the fair market value (FMV) of the company’s common stock prior to the issuance of equity compensation. As explained below, the failure to support the company’s FMV can lead to significant tax consequences for the employee receiving the options.

The FMV valuation provides support that the strike price for non-qualified stock options to be granted is not less than FMV. For stock option grants to be tax-free to employees at issuance, companies must show that the FMV of their common stock is reasonable. This is where qualified valuation professionals come into play; to ensure safe harbor, the value must be determined at an arm’s-length assessment. A valuation performed under the FMV standard meets the IRS arm’s length criteria. A safe harbor valuation is assumed to be appropriate when it is performed under the applicable 409A framework. By achieving safe harbor through the FMV valuation, the burden of proof to show that the value is unreasonable shifts from the taxpayer to the IRS.

For example, if a company’s common stock price is estimated to be $2.50 per share by an independent valuation, the company cannot issue common stock options at a strike price below $2.50 without creating a taxable event upon issuance. If a safe harbor valuation was not obtained and the IRS establishes that the options were granted below FMV, the difference between the strike price and the FMV is included in each employee’s gross income the year that 409A non-compliance is found. This tax is imposed on all stock granted to employees at less than the FMV for the current taxable year AND prior taxable years. Additionally, the IRS can levy up to a 20% penalty on stock options that vested prior to that tax year – this may result in serious financial damages toemployees. However, if the company obtains an arm’s length assessment supporting its value per share conclusion, these potential tax and penalty issues can be avoided.

How Often Are 409A Valuations Conducted and What Is Needed To Conduct the Analysis?

Companies are expected to conduct a 409A valuation once every 12 months or when a material event has occurred, whichever comes first. Material events include happenings such as new equity financing, the receipt of an acquisition offer, or significant changes to a company’s financial outlook. 

The following checklist is a sample of materials typically needed to perform a 409A valuation:

  • An understanding of the sector/industry in which the company operates 
  • Most recently amended articles of incorporation
  • Most recent capitalization table
  • Historical and projected financials
  • Estimate of options expected to be issued over the next 12 months
  • List of five publicly traded comparable companies
  • Timing of liquidity events such as an initial public offering (IPO) or an acquisition of the business
  • Significant events since the previous 409A

Common Misconceptions

Several misconceptions surround the 409A valuation process, including search for the lowest price, the strike price must equal the 409A FMV, and 409A valuations are not heavily scrutinized by the IRS.

  • “Search For the Lowest Strike Price”: Small changes to valuation inputs often do not make a significant difference in value to employees when they exercise their options. The appreciation of a company’s common stock is correlated to the progress it is making in building the business. Therefore, doing things that invalidate 409A safe harbor (such as searching for the lowest strike price) does not provide significant benefits but can expose employees to large tax penalties.
  • “The Strike Price Must Equal the 409A FMV”: Although companies cannot choose an option strike price that is lower than the valuation’s calculated FMV, it is able to set a strike price that is higher. Setting the strike price higher than the FMV can be useful in situations where a company’s enterprise value has decreased since the last 409A valuation. Given the inherent uncertainty related to projections, this is not uncommon.
  •  “409A Valuations Are Not Heavily Scrutinized by the IRS”: Not only is this statement inaccurate, but as detailed above, there are significant penalties levied against employees if the 409A valuation does not fall under safe harbor. These valuations are reviewed regularly by the IRS and often scrutinized due to the complex nature of the engagements.

How Withum Can Help

Your valuations support adviser should be fluent with the appropriate regulations, be able to apply this knowledge across multiple industries, and have a strong reputation for independence and integrity. Withum’s valuation professionals hold IRS-recognized valuation credentials, such as Certified Valuation Analysts (CVA), Accredited Business Valuators (ABV), Chartered Financial Analysts (CFA) and Certified Public Accountants (CPA). We provide more than just a valuation report – we provide a trusted partnership with dedicated professionals available to assist with all your business needs, so you can focus on what matters, running and growing your business. 

Contact Us

For more information on this topic, please contact a member of Withum’s Forensic and Valuation Services Team.