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Why You Need a 409A Valuation

The IRS enacted IRC 409A to regulate pricing of stock-based compensation because of rampant abuse of deferred compensation practices in the late 1990s and early 2000s. 

Under IRC 409A, companies must prove that their option grants are priced at or above “fair market value” (FMV), however, IRC 409A does allow companies to use a third-party valuation firm to advise a FMV.  Obtaining a 409A valuation provides a FMV for a company’s common stock, which sets the strike price at which employees can redeem shares upon vesting. 

A 409A valuation also provides protection under an IRS-established “safe harbor”, which shifts the burden of proof for noncompliance onto the IRS.  This means that it is up to the IRS to prove that the strike price is not priced at or above FMV.

When and How Often Do You Need One?

Companies commonly obtain a 409A valuation after receiving their first round of outside capital and thereafter get an appraisal every 12 months or after a material change (such as a new equity financing), as required by the law.

What If You Don’t Get One?

Be careful.  Failure to comply with IRC 409A and pricing stock options below FMV will cause adverse tax consequences (federal and state taxes, penalties, and interest can exceed 75%) for both the issuing company and the option holder.

In addition to dealing with unhappy employees, failure to obtain a 409A valuation could also place a future acquisition in jeopardy.  Acquirers will want to review all of your past valuation reports to ensure you’re properly accounting for equity grants.  Not performing regular valuation exercises can negatively impact a future deal or the timely release of funds to shareholders.