409A Valuation – The Key to Protecting Your Fund’s Earnings

Our friends at Richey May reached out to discuss valuable insights on 409A valuations – what they are, when they are needed and more.

What is a 409A Valuation?

26 U.S. Code § 409A (“IRC 409A”) is a tax rule that applies to companies offering “nonqualified deferred compensation,” which is compensation paid/received in a later tax year than that in which it was earned. The IRS views stock options granted “in the money” as nonqualified deferred compensation, which has serious consequences for the recipient:

  • The spread between the exercise price and fair market value is considered part of gross income in the current year.
  • An additional tax equal to 20% of the spread is also assessed.

A 409A valuation is an independent appraisal of the fair market value per share of a private company’s common stock that is typically used to set the exercise price of granted options in order to avoid the penalties above. The IRS will presume the valuation reflects fair market value and exclude the options from the restrictions of 409A; the burden shifts to the IRS to show that the valuation is grossly unreasonable.

When do you need a 409A Valuation?

A company needs a 409A valuation before it issues common stock options. Valuations are valid for a maximum of 12 months or until a material event occurs. It is common for companies to seek a 409A valuation after raising a round of venture financing or as an IPO, merger, or acquisition is approaching.

Who does Section 409A apply to?

IRC 409A applies to anyone subject to U.S. federal income taxation who is potentially receiving nonqualified deferred compensation, including (1) U.S. tax residents and (2) nonresidents of the United States who earn U.S.-source compensation.

How is a 409A valuation determined?

An independent 409A appraiser should follow generally accepted principles of business valuation, including considering traditional techniques, methods, and models used under the three broad approaches to value: (1) the income approach, (2) the market approach, and (3) the cost (net asset) approach. Most commonly, especially for early-stage companies, the valuation is narrowed to application of the market approach via a “backsolve” technique that leverages a recent financing round. In these cases, production of a 409A valuation report is often very fast, efficient, and affordable, as the analysis can be performed with minimal documentation and input from a subject company’s management.

For any questions on 409A valuations or to discuss your valuation needs, please contact:

Monica Blocker
Director, Business Development
(312) 450-8699

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