409A Valuation: What is it? Why is it necessary and When would you need one?

As a tech founder, there are generally two types of company valuations that you would be involved with during the life of your tech start-up. The first and the more common one is the venture investment valuation. You arrive at this valuation figure generally by negotiating with your venture capital investor. Once you agree on a valuation figure, the price per share at which you issue new shares of preferred stock in a financing is determined.

The other type of valuation is a 409A valuation. This is a totally different type of valuation. More often than not, the outcome of this type of valuation will result in a lower valuation figure than the one agreed with your investors. To be sure, your venture capital investors will typically not invest on the basis of a 409A valuation, so don’t get too worried about the lower valuation figure here.

What is a "409A Valuation"?

The phrase is a reference to section 409A of the Internal Revenue Code and the related regulations (Treasury Regulation Sections 1.409A-0 to 1.409A-6) and enacted as part of the American Jobs Creation Act of 2004. Section 409A and its related regulations set out a comprehensive set of rules regulating the taxation of non-qualified deferred compensation and outline the specific requirements for the timing of deferral elections, the designation of the time and form of payment of deferred compensation amounts.

Section 409A also covers a broad range of arrangements not typically regarded as providing for a deferral of compensation. For instance, stock options granted with an exercise price below the fair market value of the underlying shares on the grant date, as well as bonuses and severance payments, may all be classified as non-qualified deferred compensation subject to Section 409A. In simple terms, Section 409A contains a legal framework for private companies to follow when valuing private stock.

How is a 409A valuation different from a venture investment valuation?

A 409A valuation is different from a venture investment valuation because, as opposed to a valuation figured arrived at by negotiating with your venture capital investor, a 409A valuation has to be done by way of an independent third-party U.S. licensed professional, who would determine the fair market valuation of your company’s common stock, using certain valuation methodologies that are 409A compliant.

Once a valuation figure is arrived at, this is the price per share at which you must issue your stock options. It is important for an independent professional to conduct this valuation because the IRS deems such independent valuations to be fair, thereby providing a safe harbour and a shield from tax liability. Other safe harbour valuation methodologies specified by the IRS include the binding formula presumption and the illiquid start-up presumption.

When Would You Need a 409A Valuation?

You would need one:

1. Before you issue your common stock options to employees or advisors.

2. After raising a round of venture financing.

3. Once every 12 months (or after a material event).

4. If you’re approaching an IPO, merger, or acquisition.

Whether you need a 409A valuation may also depend on the structure of your tech start-up. For instance, with tech start-ups where the issuing entity is a Nigerian or UK entity, different rules apply around the timing of the taxation of stock options and the applicable procedures.  

This legal update is not intended to be taken as legal advice. Please seek professional legal advice specific to your situation. For more information, legal opinions on 409A Valuations, company formations, tax, or other inquiries, please reach out to your usual Balogun Harold or contact our team via support@balogunharold.com