How Often Do You Need a 409A Valuation?

A 409A valuation is an independent appraisal that determines the fair market value (FMV) of a private company’s common stock, particularly for those offering equity compensation to employees. This valuation is important for compliance with tax regulations and for managing equity plans.

What is a 409A Valuation and Why it Matters

A 409A valuation is an independent appraisal that determines the fair market value (FMV) of a private company’s common stock. Named after Internal Revenue Code Section 409A, which sets guidelines for nonqualified deferred compensation plans, its primary purpose is to establish a defensible strike price for equity awards like stock options issued to employees and service providers.

Compliance with Section 409A ensures equity-based compensation is appropriately valued and taxed, protecting the company and employees from adverse tax consequences. Without a proper 409A valuation, the IRS might deem stock options issued below their true FMV, leading to penalties.

For private companies, whose stock does not trade on an open market, a 409A valuation provides a formal, independent assessment. This assessment is necessary for setting the strike price for stock options at or above the FMV on the grant date. Obtaining a 409A valuation also helps a company achieve “safe harbor” status with the IRS, presuming the valuation’s reasonableness.

When a New 409A Valuation is Required

A 409A valuation is valid for a maximum of 12 months from its effective date. To maintain compliance and “safe harbor” status with the IRS, companies must obtain a new valuation annually if they continue to issue equity. This refresh ensures the valuation reflects the company’s current financial standing and market conditions.

However, a new 409A valuation may be required sooner if a “material event” occurs. A material event is any significant change that could alter the company’s valuation, invalidating an existing one.

Common material events include financing rounds where new equity is issued or preferred stock is sold. The price negotiated in these rounds provides a market-validated indication of the company’s value. Mergers, acquisitions, or secondary share sales can also trigger a new valuation, as these transactions impact the company’s ownership structure and value.

Changes in financial performance, such as revenue growth or decline, or shifts in capital structure, also qualify as material events. Other triggers include business milestones like product launches, customer acquisitions or losses, or entering new markets. Changes in the company’s business model, regulatory environment, or leadership can also necessitate a revaluation, as these factors influence future prospects and risk.

Risks of Not Complying with 409A Valuation Rules

Failing to comply with 409A valuation rules, or using an outdated valuation, carries risks for the company and its employees. Employees who receive equity compensation face the most direct consequences. If a deferred compensation plan, including stock options, does not comply with Section 409A, the deferred amounts become immediately taxable to the employee.

Employees also face an extra 20% federal penalty tax on all deferred vested amounts. They may also be subject to interest penalties for underpaying taxes.

While direct tax penalties primarily impact employees, companies also face consequences. Employers may incur reporting and withholding penalties for non-compliant deferred compensation. Non-compliance can damage company credibility with investors and talent, leading to increased IRS scrutiny during audits and potential legal liabilities.

The Process of Getting a 409A Valuation

Companies engage independent third-party valuation firms to perform a 409A valuation. These firms specialize in assessing the fair market value of private companies and provide audit-defensible reports. Selecting a qualified firm with experience valuing similar companies helps ensure accuracy and IRS compliance.

The valuation firm requires information and documentation from the company to complete the appraisal. Key financial documents include historical financial statements and financial forecasts of future revenue, expenses, and growth.

A capitalization table (cap table) detailing the company’s ownership structure, including shares, stock options, and convertible securities, is also needed. Information on recent and planned financing rounds provides market-validated pricing data. Details about the company’s business model, industry, and contracts are also requested to provide context for the valuation.

Valuators employ several methods to determine the fair market value, including the market approach (comparing the company to similar public companies or recent transactions), the income approach (valuing the company based on projected future cash flows), and the asset approach (often used for early-stage companies without revenue). The process, from data submission to report delivery, can take a few days to a few weeks, depending on company complexity and team responsiveness.