For private companies, equity compensation can be an important tool for attracting and retaining employees, executives, and other key contributors. But when a company grants stock options, it also needs to establish the fair market value of its common stock.
That is where a 409A valuation comes in.
An independent 409A valuation helps a private company determine the fair market value of its common stock for purposes of issuing stock options and other forms of equity compensation. While many companies update their valuation annually, certain events may trigger the need to obtain a new valuation sooner.
What Is a 409A Valuation?
Section 409A of the Internal Revenue Code governs non-qualified deferred compensation arrangements, including stock options.
A 409A valuation determines the fair market value of a private company’s common stock. Unlike a publicly traded company, a private company does not have a readily available market price for its shares. The valuation establishes the “strike price” for stock options and helps ensure that options are not issued with an exercise price below fair market value, which could create adverse tax consequences under Section 409A.
For companies granting stock options, maintaining a current 409A valuation can help support compliance with these requirements and provide documentation for the company’s equity compensation decisions.
When Does a Company Need a 409A Valuation?
#1: Before Issuing Stock Options
One of the most common reasons to obtain a 409A valuation is before granting stock options to employees, executives, or other service providers.
The valuation establishes the fair market value used to set the option strike price. Having a current valuation in place before granting options can help a company support that the strike price was set appropriately, critical for maintaining safe-harbor protection.
Important to Note: If you’re planning to issue options, you need a current 409A valuation – period.
#2: After a Financing Round
A new funding round can significantly affect a company’s capital structure and overall value. If a company raises capital through a new preferred stock financing, it may be appropriate to obtain an updated 409A valuation.
The price investors pay for preferred stock does not necessarily equal the fair market value of the company’s common stock. A 409A valuation should consider the differences between the classes of equity, along with the company’s financial performance, market conditions, and other factors. To measure these differences, valuation professionals use equity allocation methodologies, such as:
- Option‑pricing methods
- Probability‑weighted scenario analysis
- Hybrid methods
#3: After a Material Change in the Business
Companies do not necessarily need to wait 12 months to update a 409A valuation.
A significant change in the business may warrant a new valuation sooner. Examples can include:
- Significant revenue or earnings growth
- The loss or addition of a major customer
- A significant new product or market opportunity
- An acquisition or other major transaction
- A material change in the company’s financial outlook
- A significant change in the company’s capital structure
- An anticipated sale, merger, or other liquidity event
The key consideration is whether the event could reasonably have a material impact on the value of the company’s common stock.
Timing for 409A Valuation Updates
There is no blanket requirement that every private company obtains a new 409A valuation exactly once a year. However, a valuation generally cannot be relied upon indefinitely.
Under the 409A regulations, a valuation safe harbor can generally be relied upon for up to 12 months, assuming there has not been a material change in the company’s value. For that reason, many private companies obtain an updated 409A valuation annually. However, an earlier valuation may be appropriate when a material event occurs.
The Value of an Independent 409A Valuation
An independent 409A valuation provides more than a number for setting a stock option strike price. It provides support for how the fair market value of a company’s common stock was determined, taking into account factors such as financial performance, projections, capital structure, industry, comparable companies, market conditions, and the rights and preferences of different classes of equity.
If your company is preparing to issue stock options, has recently raised capital, experienced a significant change in the business, or is approaching a major transaction, it may be time to revisit your 409A valuation.
Considering a new 409A valuation? Contact the Evergreen Advisors Business Valuation team to discuss your company’s needs.