What does a 409A Valuation Mean?

A 409A Valuation is a formal report that sets the current value of your company's common stock and the strike price to exercise an option to purchase that stock.

Typically a company hires a professional appraiser to prepare the report since stock options set at a strike price below the current value of the common stock can result in large tax penalties to the option recipients.

Section 409A of the U.S. tax law requires that the strike price (the set future price per share to exercise a stock option) not be lower than the current real value of a share of the company's stock on the day the stock option is issued (the "grant date").

What is 409A?

409A is a section of the U.S. tax law that contains rules about the stock options some companies give their employees.

A stock option is an optional right to buy the company's stock in the future at a fixed price per share (called the "strike price" or "exercise price"). Businesses use options to reward their employees since the option locks in the price of the company's stock. If the value of the company's stock goes up, the employees can profit by buying at the lower strike price.

For example, a stock option might give an employee the right to buy 1,000 shares of company stock for a set price of $2 per share for four years after the grant date. If the employee decides to exercise the option on a future date when the stock is worth $5 per share, she would pay $2,000 to buy stock worth $5,000. (In most cases the employee will need to pay tax on the resulting $3,000 profit whether she decides to keep the shares or sell them immediately.)

Usually, options become usable in installments. This means that some shares might become purchasable ("vest") one year after being granted, while the rest of the shares might vest two years after being granted.

Why Is a 409A Valuation Important?

A 409A valuation helps protect your employees from future tax problems with the IRS. Imagine a company that didn't get a 409A valuation and grants an option that allows an employee to buy 1,000 shares of stock for $2 per share. Now imagine that the IRS later determines in an audit that the actual stock value on the grant date was $4 per share.

If the value of a share has increased to $40 by the time of the audit (and the employee's options have vested), the employee must do two things:

  • Immediately pay income tax on the difference between the current value ($40) and the incorrect strike price ($2) -- $38 per share for the 1,000 shares of option stock ($38,000) -- even if she hasn't yet exercised her options to purchase the shares. If the employee is in the 33% tax bracket, that means a $12,540 income tax bill.
  • Pay a penalty equal to 20 percent of the price difference (in this example, 20% of $38,000). So the employee now owes another $7,600 to the IRS.

In addition to the total $20,140 tax bill, the IRS will likely also charge interest on the tax bill and raise the tax bill amount even higher.

On the other hand, if the company had gotten a 409A valuation and knew the shares' real value at the time the option was given ($4 per share), the employee gets to delay paying taxes until she exercises the option and buys the stock (which could be several years after the audit).

In the example above, if the employee buys the stock at a time when it's worth $40 per share, she would owe tax in the year she exercises her options based upon the $36 difference between correct strike price ($4) and the value at the time of the exercise ($40). If she's in the 33% tax bracket, her $36,000 profit results in a $11,880 tax bill.

Reasons to Not Use a 409A Valuation

Public companies can issue stock options to employees that give them the right to buy the same shares that are sold on stock exchanges. This makes a 409A valuation unnecessary for public companies (since the market will determine the current value of the stock every business day). A 409A valuation is also not necessary if your company doesn't issue stock options.

Reasons to Use a 409A Valuation

Obtaining a 409A valuation lets a company follow the tax laws and avoid an IRS audit. Tax problems are distracting, and hiring lawyers and consultants to defend the company is expensive.

More importantly, your company should not put its employees at risk for immediate tax trouble. Stock options are a way to reward and keep good employees -- not leave them with a huge bill from the IRS.

Deadlines for a 409A Valuation

There are 3 major scenarios when a 409A Valuation should be used:

  1. The company issues its first employee stock options.
  2. 12 months have passed since the last 409A valuation.
  3. The company experiences big changes (such as admitting outside investors or generating its first revenue or profits).

Common Mistakes With 409A Valuation

  • Don't hire an inexperienced appraiser. A badly done appraisal will only create more problems down the road.
  • Get input from your company's accountants before choosing an appraiser. If the IRS does an audit, your appraiser will need to work closely with your accountants.
  • Don't pressure the appraiser to come back with a lower strike price. The appraiser might refuse to issue the 409A valuation report or refuse to defend the valuation if the IRS audits your company.

Frequently Asked Questions

  • What happens if my company doesn't comply with 409A?

    The IRS may audit the company, which will force it to spend valuable time and money defending itself. Even worse, the employees who received the options must pay added taxes and penalties.

  • Does it ever make sense for a company to do the 409A valuation itself?

    Although this is technically permitted under 409A, a company will have an easier time in a dispute with the IRS if an outside appraiser prepared the valuation report.

Steps to Find Your 409A Valuation

Hire a reputable appraiser with professional credentials and experience doing 409A valuations. Your company's accountants should be able to recommend appraisers.

Cooperate with your appraiser by providing the documents and other information requested and by making the company's management available to answer questions.