Considering offering stock option allocation to your employees?

Stock options are one of the greatest attractions for innovative, highly motivated employees in startups. The problem is, that offering stock options has taxation consequences it is best to prepare for – starting with the performance of a 409A valuation.

But what exactly is a 409A valuation?

409A is a section of the U.S. tax law that contains rules about the stock options some companies give their employees. Basically, a 409A valuation is the assessment of the fair market value of your company’s shares.

This will determine the “strike price” at which your employees can purchase an equity in your company. Generally, businesses use options to reward their employees since the option locks in the price of the company’s stock. If the value of the company’s stock goes up, the employees can profit by buying at the lower strike price.

Of course, the employee only benefits if the stock is not overvalued when he is offered the option – and that’s where the 409A valuation kicks in.

But I know what my company is worth, and so do my employees! Can’t I simply value it myself and have my employees sign off on the stock options?

No, you can’t. a 409A valuation is required by law and failing to fill it will open your company up to charges on undervaluation and major taxation penalties.

This means that you are obligated to perform a 409A valuation every time your company concludes a new funding round, as well as every 12 months. You also need to carry out a new valuation when your company undergoes major changes (such as admitting outside investors or generating its first revenues).

Is a 409A Valuation really that Important?

Yes, it is. Not only is your company exposed to penalties if it is not performed, A 409A valuation also helps protect your employees from future tax problems with the IRS. If the IRS determines that stock was undervalued at the time it was offered to the employee, the IRS will require your employees to immediately pay the income tax on the difference between the current value of the stock and the undervalued stock price – even if the employee has yet to exercise their options to purchase the shares. On top of that the employee will be required to pay a penalty equal to 20 percent of the price difference – and on top of that likely charge interest on the tax bill.

Wow! I guess not many employees would want to get stock options that expose them to those kinds of penalties!

That’s right – and that, perhaps, is the most important reason to perform the valuation correctly. You want to offer stock options as a reward and an inducement to high performance employees – if your employees end up being harmed by accepting the stock options then you will not be achieving the desired effect!

Well, I’m convinced – so how do I get the 409A valuation done?

Well, one way is to do it yourself. That is not recommended, because that means you cannot blame anyone but yourself if the IRS chooses to become involved and demand proof that your valuation is correct. Using software does not much reduce the likelihood of errors and in any event only very early stage startups are eligible for this option. The safest option is to hire a credited professional. If the IRS chooses to question his valuation then it is they who will have to bear the burden of proving the valuation is incorrect, rather than you being required to prove that it is correct. 

The whole process generally takes between two weeks to a month.

Is there any reason not to use a 409 valuation?

Well, public companies can issue stock options for shares that are sold on stock exchanges which makes a 409A valuation moot. And of course, there is no need for such a valuation if the company does not issue stock options.