The term 409A refers to Internal Revenue Code (IRC) Section 409A, which covers taxation of nonqualified deferred compensation. Deferred compensation refers to any compensation to be paid in a future taxable year based on current services provided and the deferral is not elective, such as a 401(k) plan. Section 409A allows employees, consultants, and other service providers to avoid immediate taxation of equity-based compensation awards (typically in the form of common stock options) as long as the equity is granted with an exercise price at or above the Fair Market Value (FMV) as of the grant date.
Section 409A contains several provisions for private companies that, if followed, will provide protection against any potential IRS audit and place the burden on the IRS to demonstrate that the determination of the FMV was “grossly unreasonable.” These provisions, commonly referred to as the 409A Safe Harbor Provisions, allow for valuations to be determined:
By an appraisal prepared by an independent, qualified appraiser as of a date that is (a) within 12 months of the grant date or (b) on or subsequent to a value-changing event occurring within a 12-month period prior to the grant date (herein referred to as the Independent Appraiser Provision);
Based on a formula that would be considered to be FMV of the subject equity under certain criteria and applied in the same manner for any transfer of such equity; or
By a written report by an individual with “significant knowledge, experience, education, or training” in business valuation, investment banking, financing, accounting, and/or related professions for any equity that meets the definition of “illiquid stock of a start-up corporation” as detailed in Section 409A (herein referred to as the Illiquid Stock of Start-up Provision).
In our experience the Independent Appraiser Provision is most commonly followed with the Illiquid Stock of Start-up Provision occasionally followed when grants are made at a company’s inception, before any third-party funding, and the founding team includes a “qualified” individual. Ultimately, the Independent Appraiser Provision allows a company to mitigate additional risk (as compared to the potential consequences of non-compliance and/or an adverse finding by the IRS) and place the burden on the IRS to demonstrate that the estimated FMV is "grossly unreasonable" for a relatively minimal fee.
When should a 409A Valuation be prepared? A 409A Valuation should be performed as soon as a private company wants to begin granting equity awards then an updated 409A Valuation should be performed every 12 months or following material, value-changing event, typically considered to be a financing round (please feel free to reach out to us if you have any questions about whether a recent event, development, milestone, etc. might trigger the need for an updated 409A Valuation). As a best practice, companies at later stages of development (particularly leading up to a potential IPO) will have more frequent, regular updates performed, but we recommend companies at earlier stages of development only perform updates every 12 months or post-financing.
Please note that the above discussion was intended for informational purposes only and should not be considered tax, legal, or related advice/guidance. In addition to speaking with a business appraiser, Concept Analytics LLC recommends obtaining advice/counsel related to any potential valuation needs with your tax, legal, and related advisors as appropriate.