What is a 409A valuation and does my company need one?

In the world of startups, it can be challenging and complicated to adhere to local regulations as you expand overseas, especially if you're a founder or an employee of an early-stage company. One such regulation that often comes up when discussing share price and employee share (stock) options plans (ESOP) in the U.S. is a ‘409A valuation’.

What exactly is it, and why is it crucial if your company is either registered in the U.S. or if you’re offering share options to US-based employees? Let’s break down the basics of 409A valuations and explain why they are essential for many Kiwi and Australian companies exporting into the U.S. market.

What is a 409A valuation?

A 409A valuation, named after the section of the IRC (Internal Revenue Code), is an independent appraisal of the fair market value (FMV) of a company's ordinary shares. The primary purpose of a 409A valuation is to determine the exercise price for share options issued to employees, consultants, and other service providers.

Importantly, this exercise price ‘may never be less than the FMV of the underlying stock on the date the stock right is granted.’

In simpler terms, having a 409A helps set the price at which employees can buy shares of their company without either the company or employee attracting unfavourable tax treatment.

Why do you need a 409A valuation?

• Compliance: The most common (and important) reason for obtaining a 409A valuation is to ensure compliance with the IRS regulations. The IRS requires private companies to issue share options at a price that reflects the FMV of the company's ordinary shares. Failing to do so can result in severe tax consequences for both the company and the employees who received the options.
• Avoiding Penalties: If the IRS audits your company and finds that your share options were not issued at the FMV, they can impose substantial penalties, including taxes on the option recipients and additional taxes on the company itself. These penalties have the potential to be financially crippling for startups that are looking to expand their global footprint.
• Employee Compensation: Offering stock options is a common way for startups to attract and retain top talent. However, if the options are not priced correctly, employees may face unexpected tax liabilities when they exercise their options. This can lead to dissatisfaction and turnover among your employees.
• Capital raising and Investors: Investors, especially US-based VCs, often require a 409A valuation before investing in your company. A valid 409A valuation provides assurance to investors that your company is following regulatory compliance and that the share options offered to employees have a fair and accurate exercise price.
• Mergers and Acquisitions: If your company is involved in a merger or acquisition (especially with a US-based company) then a 409A valuation can be important in helping to determine the value of the company's shares and, consequently, the value of the deal. Having a defensible valuation can help ensure you get a fair deal.

How to get a 409A valuation

Getting a 409A valuation typically involves working with a third-party valuation firm or a qualified appraiser. Here's a general overview of the process:

1. Engage a 'valuation firm': Choose a reputable valuation firm or appraiser with experience in valuing early-stage companies. It’s important to note that not all providers are created equal, and there are horror stories of startups being punished for inaccurate 409As. TIP: Orchestra works with a few reputable providers; get in touch with our team to learn more.
2. Provide company information: Your chosen 409A provider will request detailed financial and operational information about your company, including financial statements, business plans, and recent funding rounds.
3. Valuation analysis: The valuation firm will analyse your company's financial data, market conditions, and other relevant factors to determine the FMV of your ordinary shares.
4. Documentation: The firm will provide a detailed report documenting the valuation methodology and supporting data. It varies, but you can expect a minimum of a 20-page report.
5. Update annually: While they can be costly, 409A valuations should be updated annually or when significant events occur, such as fundraising rounds or material changes in the business.

It’s also important to note that auditors favour a 409A valuation supplied by an independent provider.

Kiwi and Australian startups must understand and comply with US regulations, such as ensuring a 409A valuation is used for determining the ESOP exercise price. Failing to do so can lead to costly consequences for both the company and its employees. By obtaining a 409A valuation, you not only ensure IRS compliance but also create transparency and fairness in the issuance of share options, which is crucial for attracting and retaining talent and building investor confidence. So, whether you're a founder or an employee, remember that a 409A valuation is not just a legal requirement; it's a valuable tool for your company's growth and success.

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