Do I really need an expensive 409a valuation report to tell me that my startup is worth nothing?
For many startups, the short answer is “no.” Some startups can create their own 409A valuation report for $0 using a DIY 409A calculator.
Few regulations are more annoying to early-stage entrepreneurs than IRC 409A. This regulation requires that stock options be issued with a strike price equal to or above the value of common stock. This means that all startups — no matter how early the stage — must have a business valuation performed before issuing stock options to justify their choice of strike price.
And the risks of non-compliance with IRC 409A are severe – if found in violation, option holders must immediately pay taxes on all vested shares, an additional 20% penalty tax, and even interest on the unpaid taxes. This is why private companies generally seek out a 409A valuation from an independent valuation services firm before issuing options.
The typical 409A valuation costs anywhere from $1,200 to $5,000+. For startups in the earliest stages of development, this seems like a huge waste of time and money – time and money that could be spent growing the business.
So if your company has no revenue, no proven business model, and virtually no assets, why should you pay someone to tell you what you already know (that your stock is worth very little)? It seems like there ought to be a way to eliminate or at least minimize this cost.
Well, there is. But only for the earliest stage startups. If your company meets Capshare’s 7 DIY 409A Valuation Criteria, you should be able to do your 409A valuation for free in just a few minutes.
Capshare’s 7 Do-It-Yourself 409A Valuation Criteria:
1. Your company has not yet found a source of consistent revenue
2. Your company has not raised more than $500K
3. Your company has not raised money through a convertible security instrument (KISS, SAFE, convertible debt)
4. Your company has no preferred or convertible securities
5. Your company does not reasonably anticipate an IPO in the next 180 days or an acquisition in the next 90 days
6. No shareholder has sold his or her stock in a secondary sale (different from the company issuing new stock)
7. Your company has less than $100K in assets
If your company fits this profile, and you are looking for a free 409A valuation, check out the Capshare 409A Calculator.
Why Does a Company Need a 409A Valuation?
Stock options have a strike price specifying the price at which stock may be purchased if the option is exercised. IRS regulations require you to set the value of the strike price equal to the fair market value (FMV) of your company’s common stock or face some awful tax consequences.
Most people use the term 409A compliance to refer to compliance with two sections of IRS law: IRC 409A and IRC 422. There is some confusion among entrepreneurs about the difference. In short, IRC 409A relates to NSO stock options and IRC 422 relates to ISO stock options.
But in both cases, you must issue your stock options at the FMV of your common stock. In fact, any ISO options NOT issued at the FMV automatically become NSO options and then fall under the jurisdiction of IRC 409A.
So what are your options for complying with 409A? Basically, you need to either pay for a valuation or perform one yourself. The valuation serves as evidence that you are not arbitrarily setting a ridiculously low strike price on your options, but are indeed setting them equal to the FMV of your common stock.
What Is The Right 409A Solution For My Company?
Choosing a 409A solution is a lot like choosing an insurance product. Your decision depends on your risk tolerance and how much you are willing to spend to decrease your risk.
To understand the risk, you need to understand:
the standards the IRS has set for compliance
the potential of being audited,
the likelihood of failing an audit, and
the penalties of non-compliance.
IRS Compliance Standards
The IRS has offered some general standards for compliance.
IRC 422 requires companies to make a “good faith” effort to value their stock. If “there is a failure in [the] attempt,” as long as the company made a “good faith” effort, the requirement shall be considered to have been met.
IRC 409A specifies that a valuation meeting certain defined criteria will put a company in “safe-harbor.” Safe-harbor is a very important legal term when considering 409A valuation options. If a valuation qualifies for safe-harbor, then the burden of proof shifts to the IRS. This basically means two things:
You do not have to prove that your valuation is correct.
If the IRS has an issue with your valuation, the IRS must prove that your valuation was “grossly unreasonable.”
This provides enormous protection when it comes to audit and tax risk. Proving something is “grossly unreasonable” is very difficult, especially if you have taken some basic precautions.
So what qualifies a valuation to achieve safe harbor? The following conditions must be met:
The valuation must be performed by “qualified individual(s)” or by an independent appraiser.
The valuation must be performed within the last 12 months.
The valuation must be evidenced with a written report.
“Qualified individuals” includes anybody with a set of experiences that would allow a company to reasonably rely on their valuation work. The IRS doesn’t give much more information about “qualified individuals,” but industry commentators have often included the following individuals in the qualified group:
Directors or board members with significant financial, investing or valuation expertise
CFOs with valuation knowledge
Angel investors or venture capitalists
Investment bankers or private equity professionals
Because of the ambiguity in the definition of “qualified individuals” and because performing a 409A requires certain technical expertise (notably allocating a company’s value among various classes of stock), many industry commentators feel that trained and experienced valuation professionals are the only safe option.
If a valuation meets certain “safe-harbor” standards, the IRS must prove that the analysis is “grossly unreasonable” in order to enforce any kind of penalty. If a valuation is not under safe harbor and the IRS challenges the valuation, then the company must prove to the IRS that their analysis is sound and accurate to avoid penalties.
Since IRC 422 only requires a “good faith” estimate, it may be that the IRS doesn’t expect companies granting ISOs to get a full-blown safe-harbor valuation from a valuation services firm. Since it isn’t immediately clear what constitutes a “good faith” estimate, most companies that can afford it choose to still get the standard 409A valuation as this certainly qualifies as “good faith.”
The Potential for an IRS Audit and the Likelihood of Failing
Many industry commentators have pointed out that the IRS has never brought an enforcement action against a company for a 422/409A violation in over 10+ years. As of 9/1/2015, this is still true.
But in our experience, it is never wise to flippantly dismiss any IRS-related risk. The IRS has recently requested some information from about 50 companies to see if they would like to become more active in 409A compliance.
Ultimately, we feel that the risk of an audit is very low for a startup company that takes some very basic steps, such as using an online calculator and asking a few financial experts to review the results.
Valuing a private company is notoriously difficult and subjective. We believe it would be difficult for the IRS to definitively prove an incorrect valuation. So they would have to focus on a lack of effort.
The Penalties of Non-Compliance
We recently published an article that addresses this: Just How Bad Is 409A Non-Compliance for a Startup, Really? The punchline is that 409A non-compliance could be really painful and you definitely want to avoid it.
Making a Decision
In essence, there are three types of 422 / 409A valuations you could consider (from highest to lowest risk):
Valuations you perform by yourself
Valuations performed by a qualified individual (depending on the individual, this may meet the safe-harbor and good faith tests)
Valuations performed by a qualified, independent appraiser or valuation services firm (meets safe-harbor and good faith tests)
The cost of these valuations increases as you move from the higher-risk options to the lower-risk options.
Unless you happen to be a “qualified [valuation] individual”, option 1 will not meet a safe-harbor test but could meet a “good faith” test provided you used some software. The good news is that you can use Capshare’s 409A Calculator to do this for free.
If you prefer a lower risk valuation, you’ll want to hire an independent valuation services firm. You can do this at a low cost with a $99/month 409A subscription through Capshare. Most other firms will charge you between $3,000 and- $5,000+ per valuation.
Ultimately, you need to decide the likelihood of a challenge by the IRS, and whether or not you would feel comfortable defending your valuation to the IRS. For very early-stage startups, the risk of any IRS involvement is low.