If you grant stock options to US employees, you need to know the fair market value of your common stock. That is what a 409A valuation provides, and getting it wrong can create a tax problem for the people you are trying to reward.
What it is
A 409A valuation is an appraisal of the fair market value of a private company's common stock. It sets the minimum strike price for stock options, so that options are not granted at a discount. The name comes from Section 409A of the Internal Revenue Code, which governs deferred compensation.1
Why it matters
If options are granted below fair market value and do not comply with Section 409A, the consequences fall mainly on the employee. According to Carta, they can include immediate taxation of the deferred compensation, an additional 20% tax, and interest.1
Safe harbor
The most common way to protect the company and its employees is the independent appraisal safe harbor: using a qualified, independent appraiser. With a safe harbor valuation, the burden shifts to the IRS to show the valuation was grossly unreasonable.1
How long it lasts
- A 409A valuation is generally relied on for up to 12 months, or until a material event, whichever comes first.1
- Material events include a new priced financing, an acquisition offer, or a major change in the business.
- Carta says a valuation typically takes one to three weeks, depending on how complex the company is and how quickly information is provided.1
When to get one
- Before you grant your first stock options.
- After a priced round or other material event.
- At least once a year while you are granting options.
What diligence will check
- That every option grant had a current 409A valuation at the time of grant.
- That strike prices were at or above the 409A value.
- That the board approved each grant and the valuation it relied on.
This guide explains how 409A valuations commonly work. Talk to your tax advisor and a valuation provider about your situation.