What New Founders Need to Know About 409A Valuations

In the early stages, founders find themselves in a position to officially determine the fair market value of their company’s equity without understanding how to do it. Valuation may arise with the issuance of stock options or stock sales. What do new founders need to know about Internal Revenue Code Section 409A qualification for a safe harbor?

The IRS regulates the rules associated with nonqualified deferred compensation. Deferred compensation exists when a service provider, whether an employee, advisor, consultant or board member, has a right to compensation that will be paid in later taxable years.?The recipients of this compensation are generally referred to as service providers. The 409A valuation is an independent appraisal of the fair market value of a private company’s common stock, including the stock reserved in an equity incentive plan. This valuation determines the price per share of the private company’s common stock.

What influences a 409A valuation? The method used to determine your 409A valuation is the most important decision to make. In some cases, you may need to use more than one method. The IRS will look at the evidence of the factors used to determine the fair market value of the equity. This evidence may consist of stock studies and comparative analysis. You, as a founder, will need to save this data to back up the determinations. Additionally, can the valuation be used for financial reports and taxes? It would be best if you make sure the valuation is appropriately done so it can be used for any purpose for which it is needed.?

When is the appropriate time to obtain a 409A valuation? There are three significant times when this will need to occur.

·??????When you decide to grant stock options to your service providers.

·??????Upon expiration of the most recent 409A valuation, which is only valid for 12 months.

·??????When you are about to enter into a sale of your company’s equity.?

Having a safe harbor for your company means that any burden of proof for your valuation would be on the IRS if they choose to audit your company. The IRS would have the burden to discredit your facts, figures, and documents. If you do not have a safe harbor, you get audited, and if the audit results are not in your favor, the IRS would immediately tax your service providers on the compensation. This might even include an extra 20% fine and additional penalties. For these reasons, most companies hire a third-party valuation professional to conduct their 409A valuation.

The three ways to obtain a 409A valuation have specific requirements to qualify for the IRS safe harbor. Let’s discuss each in more detail.

Many founders want to know if they can determine the fair market value of their stock on their own. The answer is yes, so long as you adhere to the IRS guidelines. So long as you have relevant knowledge, financial training, education, and experience (all defined by the IRS), you can perform the 409A valuation yourself. This method saves money and time. This method may not give you the necessary safe harbor protection, however, because the burden of proof is on you. Although this method is not considered the best, it is the one most used by early-stage companies because of the cost savings.?

Other founders obtain a subscription for software that can assist with the calculations for determining the 409A valuation. This method saves the company time preparing the report and helps save some money on hiring a professional. The downside of this method is that you will not get safe harbor protection. If the IRS audits you, the burden of proof is on you. Further, not everyone can use this specialized software, and most do not meet the criteria to use it properly. This method leaves you with the exposure you may not want.

The best and most reliable option is to hire a professional valuation expert or firm to perform your 409A valuation. This method gives you safe harbor protection because the burden of proof is removed from you in the event of an IRS audit. This method also provides for a more acceptable valuation process when it comes time for investors.?

A lot goes into the 409A valuation, which can make the process confusing and complicated. Contact Afissio with any questions related to your 409A valuation. We will be happy to introduce you to our preferred 409A valuation expert who provides dependable 409A valuations at a reasonable price. You can email us at [email protected] or book a call with us here.

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