Question: What is involved with a 409A valuation?
Answer: A 409A valuation is essentially a business valuation done to comply with the IRS rule that governs anything they believe is “deferred compensation”. They consider the typical stock options that most companies grant to be deferred compensation for the employees. As such to avoid creating a taxable event for the option recipient they guide companies to grant those stock options with a strike price that is equal to the fair market value of the underlying stock at the time of the option grant.
Fair market value means the price at which a willing buyer and willing seller with neither under any duress to buy or sell would transact and consider fair. That price is almost always set by obtaining an independent fair market valuation report from an independent party that is qualified to appraise businesses and securities.
So, what is involved in securing that independent opinion of value is that you engage someone to provide that service and you then provide them with background information that the company likely already has. Things like historical financial statements (audited is great, but not necessary), a background on your business (often via pitch materials), a detailed ownership table / cap table, the company’s Articles of Incorporation, and other items that are generally standard to have on hand. When we request information from our clients it typically takes them around 30 minutes to answer our questions and upload needed diligence files into our webform.
Question: When is the right time to do a 409A valuation?
Answer: When the IRS implemented 409A they wanted to avoid companies playing games with their stock options, but also from the comment period tried to avoid making this fair market value valuation requirement too onerous for private companies that are time constrained and fee sensitive. As such they landed on having these valuations good for one year unless a material event occurs during that year.
The reality is that these are not like a business license where someone checks to ensure you always have a current one. Companies have largely self-regulated on this IRS requirement. Some of that is because their auditors encourage them to keep these current as an input for the GAAP reporting of stock-based compensation expense (AKA ASC 718).
Companies granting stock options should always do those grants using a current 409A report. So if the last report is more than a year old or if a material event has occurred then they will need a new valuation report to comply with 409A. What constitutes a “material event” is left up to some interpretation, but generally has been understood to mean a funding event where a new price has been established for the company’s equity (e.g., a priced preferred round). So issuance of SAFE notes or convertible notes doesn’t necessarily constitute a material event unless the company prefers an abundance of caution on how they define material events.
Sometimes a company will have a question as to whether to get a valuation in advance of an anticipated material event to lock in a lower strike price of options they want to grant immediately. This can provide the recipients of those options a lower strike price, given the material event isn’t certain until it happens. But if that event is known or knowable, then the difference might be marginal and might not be worth the extra fee and distraction. That said, many clients have requested valuations in advance of events when they feel every penny counts to their option recipients and they don’t mind paying for two valuations in the space of a relatively short time frame.
Ultimately the right timing can be somewhat situational and talking with the valuation provider can be helpful to determine the right timing/game plan for your company. If the firm is pushing you to get a valuation, then they may be more self-interested than a true trusted advisor. But hopefully most firms would seek to dispense good advice, we certainly try our best to do this.