Disclaimer: We are not lawyers, and this is not legal advice. Although we try to make sure our information is accurate and useful, please consult a lawyer if you want legal advice.
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What is a 409A valuation, and why do I need it?
If you are planning to offer stock options to employees, you will need to do a 409A valuation to comply with legal requirements. A 409A valuation is an assessment of your private company's common stock price, which then becomes the option exercise price for employees. The lower the share price determined through the 409A valuation, the less expensive it is for employees to exercise their options.
Option exercise price: Also called "strike price" or "grant price," this is the specified price at which your employees can purchase the stock.
Step 1: Do I need to get a 409A valuation?
You need to get a 409A valuation before you issue options. Even if you do not plan on issuing options, you need one if a material event has occurred (e.g., a new fundraising round). After your first 409a valuation, you then need to update it (a) at least once every 12 months, and (b) whenever a material event has occurred.
Material event: something that affects the value of the company. A standard material event is closing an equity fundraising round. Even fundraising rounds of convertible notes and SAFE notes can count, especially if they have a valuation cap. [1] Other material events can include: acquisitions, secondary sales of common stock, significant changes to your company's financial outlook, upcoming IPO.
Step 2: What are the different methods of getting a 409A Valuation?
Depending on your risk tolerance, there are two different ways to get your 409A valuation. The main differences in these options are the cost, the effort, and the risk of non-compliance with the good faith requirement, and whether you have safe-harbor.
Good Faith: IRC 422 requires you to make a "good faith" effort when valuing their stock. Note: this is quite a vague requirement, so it is not clear what is sufficient to be considered "good faith."
Safe-Harbor: IRC 409A indicates that if a valuation qualifies for safe-harbor, then you are largely protected in the case of an audit. If the IRS challenges the valuation, they must prove that your valuation was "grossly unreasonable," which is challenging to do. If a valuation does not qualify for safe-harbor and the IRS challenges the valuation, then the burden of proof is on you to prove that the analysis is sound and accurate to avoid penalties.
Option 1: Hire an independent valuation firm
This is the option recommended for most startups because it qualifies you for safe-harbor.
Cost: High, $1000 - 5000+
Effort: Medium, need to hand over documents, review draft report
Time: Depends on the firm, can range from 4 days - 30+ days
Compliance & audit defensibility:
✓ Qualifies for safe-harbor
✓ Compliance with the good faith requirementValuation: You could be more likely to get a lower valuation using a more expensive firm, because building a justifiable case for a low valuation may take more time.
Option 2: Do it yourself
Typically, this option is not recommended unless the person conducting the valuation is a "qualified individual."
"Qualified Individual": are not clearly defined by the IRS, but industry commentators define them as individuals with significant valuation expertise that may include the following individuals: directors or board members, CFOs, investors, investment bankers or private equity professionals, valuation professionals. Most industry commentators agree that working with a reputable valuation firm is the only way to guarantee safe-harbor because the definition of "qualified individuals" is so ambiguous.
Cost: Low
Effort: High
Time: High
Compliance & audit defensibility:
✗ May or may not qualify for safe-harbor because the definition of "qualified individuals" is ambiguous.
✗ May or may not comply with the good faith requirementValuation: Although you may be able to get to a lower valuation, the lower the valuation, the higher the risk that the IRS will audit your startup.
A note on audits: Startups rarely get audited, and there has not been an enforcement action against a startup for a 422/409A violation in over ten years However, this could change at any time. It may be helpful to think of your 409A valuation like an insurance policy - pay now to avoid the small risk of high penalties in the future. The penalties of 409A non-compliance could cost employees hundreds of thousands of dollars in taxes, interest, and fees. [2]
Step 3: How do I choose a valuation firm?
Assuming you've chosen to go with Option 1, now you need to figure out which valuation firm to use.
Pulley works with 409A valuation experts to build a defensible report for your startup. Learn more about how to get your 409A valuation through Pulley here.
Questions to vet potential firms
How many years of experience does the firm have valuing startups at my stage? The IRS recommends 5+ years. [3]
Does the person performing the valuation have the proper credentials (ABV, CPA, ASA, CVA)? While the IRS does not require these credentials, they are a bonus.
Does your 409A valuation report qualify for safe-harbor protections? The answer should be "Yes."
Have any of your 409A reports been audited? What is your audit defense success rate? Ideally, the firm has faced audits before, and has successfully resolved them.
Is audit defense included in the price? The answer to this question should be "Yes."
Can I see a sample report?
Step 4: What is the process once I've chosen a firm?
Each firm has a slightly different process. A typical process may go like this:
Complete a questionnaire and upload documents on the firm's website.
If needed, have an initial call with the analyst(s) to discuss your business and answer any questions about the information provided previously.
Once the analyst(s) sends you the report, you can review the report and have another call to go over any questions you may have.
Finalize the valuation.
What information will I need to submit?
Each valuation firm will have a different list of documents they will request you to submit. This list covers the most common requests.
Company details
Description of your business (your pitch deck or recent board presentation may suffice)
List of comparable public companies and competitors (if known)
Financial
Cap table from Pulley
Expected number of options to be issued in the next 12 months
Historical financial statements
Year-to-date financial statements as of the valuation date
Any financial projections
Cash burn and runway
Legal
Articles of Incorporation
Any term sheets
Step 5: What do I do with my 409A valuation report once I receive it?
Upload it onto Pulley. Under the “Company” section of the left-hand menu, click on “409A”. Then click on the “Add a 409A Valuation” button on the top right-hand side of the page.
All stock options issued from the date of the latest report (until the date of any future report) will have an exercise price equal to the common share price determined by the report.