22 Feb What a 409A Valuation Is and What It Is Not
409A valuations can be one of the most confusing aspects of representing startups. One of the most common conversations I have with founders is that most companies want their 409A valuation to be lower rather than high. Why would a company want a low 409A valuation, isn’t the idea that the company try to get a high valuation for a financing or an eventual sale?
First, what is a 409A valuation and why is it necessary for a startup? Section 409A of the tax code regulates nonqualified deferred compensation paid by a “service recipient” (the employer) to a “service provider” (the employee or independent contractor) by generally imposing a 20% excise tax when certain design or operational rules contained in section 409A are violated. The 20% excise tax imposed by the IRS for violations of Section 409A is in addition to other penalties imposed on the service provider and can be disastrous.
The area where Section 409A comes into play for most startups is with respect to the grant of stock options or restricted stock to its employees and consultants (i.e., the service providers). In order to be exempt from the provisions of Section 409A, stock options must be granted to a service provider at fair market value. The problem for startups is that unlike public companies whose stock price is publicly available at any given time and constitutes fair market value, no public market exists for startup stock and therefore its fair market value is not easily discernable.
Recognizing the problem for startups, the IRS created a “safe harbor” for startups to eliminate some of the uncertainty of what fair market value is for purposes of complying with Section 409A. If a private company gets a 409A valuation that complies with certain technical rules set forth by the IRS, the 409A valuation serves as a fair market value of the common stock of the company. Therefore, if the startup grants stock options with an exercise price equal to the fair market value of each share of its common stock as determined by the 409A valuation and follows certain other rules, the burden to prove that the stock options exercise price was not at least at fair market value shifts from the taxpayer to the IRS. In the absence of a 409A valuation, the burden to prove that the stock options had an exercise price equal to at least the fair market value of the common stock lies with the employee who received the options or restricted stock and exposes the service provider to the severe penalties associated with non-compliance with Section 409A.
So, now that you know what a 409A valuation is and why it is necessary, let’s discuss what a 409A valuation is NOT and why companies almost always prefer low 409A valuations. A 409A valuation is not necessarily an accurate valuation of what a startup’s true valuation is when it goes to raise money from investors in an arm’s length negotiated transaction. Most startups issue cash investors in the company preferred stock as opposed to common stock. While the terms of preferred stock vary from company to company (and even between different classes of preferred stock issued by a single company), the key term that distinguishes preferred stock from common stock is the liquidation preference. Simply put, the liquidation preference means that holders of preferred stock get their money back first in any liquidation or sale of the company. That said, a 409A appraisal is required to consider all the material facts known at the time the appraisal is obtained.
Note that the 409A valuation is of the common stock of the company, not the preferred stock. It provides a fair market value of the common stock, not the company as a whole. The lower the exercise price for the stock options, the larger the spread per share as the value of the shares underlying the stock option grows. This potentially large economic opportunity for holders of stock options allows startups to hire new employees with lower cash compensation under the theory the employee can more than make up the difference through the potential increase in equity value associated with stock options. For example, the 409A valuation for a startup that has issued an initial round of preferred stock with basic terms is usually between 10% and 30% of the price at which the preferred stock was issued. If the startup does well and its true value rises, the value of the common stock and the preferred stock starts to converge such that in the case of most startups, at the time of a sale or initial public offering, the common stock and the preferred stock have the same value per share. But the purpose of the 409A appraisal is to provide the value of the startup before the IPO.