We understand that the last thing any startup wants to worry about is the taxes and legal side of running a business. It’s easy to let tax considerations slide when you have so many other things to worry about, like raising your angel funding or venture capital. But every startup needs to think about tax law early on to avoid confusion later. As with all things government related, it’s complicated and can impact your company greatly.
What is a 409A Valuation and Why Do Startups Need it?
The Internal Revenue Code (IRC) Section 409A is meant to regulate how companies treat what’s called “nonqualified deferred compensation” that they give to their employees instead of a higher salary. A valuation is usually performed to help companies set the strike price for any employee stock options they choose to issue, and those options have to meet Fair Market Value or come in above it. It’s best to have an objective and qualified third-party perform the valuation, which usually means hiring an appraisal firm.
409A is mostly meant to ensure that the proper federal income taxes are paid on deferred compensation plans, but it also ensures that company options are covered by the IRS safe harbor. Not complying will result in the federal government taxing you and your employees for that stock and slapping you with heavy fines, usually a 20 percent tax, as well as interest payments. It will not only make your employees extremely unhappy (to say the least), but it can also put the acquisition of your company in jeopardy. After all, what buyer wants to deal with the tax risk and indemnities you’ve incurred for not following the tax code?
How Do You Know When You Need a 409A Valuation?
Let’s say, for example, that you want to hire top-notch talent, but you don’t quite have enough money to pay their salaries. So, you offer them stock options in the company instead—the nonqualified deferred compensation referred to in Section 409A. If a startup CFO wants to offer stock options to employees, then the company needs a 409A valuation in order to comply with federal tax code regarding the strike price for those stock options.
Usually, a startup CFO wants to put off their company’s valuation until after their Series A funding because many appraisal firms will charge around $5,000 for a 409A valuation, which is generally not worth it until the company has the funds to cover it easily. However, if your company is ready to create and grant options to employees, then you’ll need a 409A valuation to ensure that your option plans are covered by the IRS safe harbor.
Getting Your 409A Valuation Started
If you’re ready for a valuation, then you want to get a qualified third-party to perform the valuation in order to determine that the Fair Market Value is accurate and reasonably calculated. There are plenty of appraisal firms you can hire for the job, and normally a startup CFO would handle the details. Once you start granting options, you’ll need to update your valuation at least every 12 months, if not more often, depending upon the growth of your company. Of course, if you aren’t at the point where you can hire a CFO, Early Growth Financial Services offers start-up consulting to help you manage things like 409A valuations, as well as accounting services and CFO services. Dealing with federal tax code can be daunting, of course, but you don’t need to face it alone.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.