When employing Americans and offering equity-based compensation to them, a 409A valuation becomes important, as it's the only way to offer stock options by the regulations of the US tax revision and avoid high taxation. Although the 409A is commonly known as option price modeling (OPM) this two are not alike. This article will explain the difference between them, and will shed light on this important but not fully understood 409A.
What is Section 409A?
It is a US regulation for non-qualified deferred compensations obligated an added income tax of about 20% on top of the regular tax. In order to assist startups and encourage them, the IRS offered an exemption to section 409A for stock-based compensations.
What is a 409A Valuation?
It is a process that its end result is the estimation of a private company’s common stock price. A public company in most cases is traded in an exchange market and therefore already has an updated stock price, in a private company the stock price is often arbitrary and the exercise price tends to be freely estimated over the company’s course.
The United States established the 409A of the Internal Revenue Code (IRC) in order to define a specific way to tax stock options given as an incentive to employees. In order to avoid this harsh taxation, the US gave a few ground roles to follow, one of them is to allocate the stock option with an exercise price equal or greater than the Fair Market Value (FMV) of common stock, This FMV calculation is called a 409A valuation.
What is the difference between 409A and OPM?
An OPM or in its full name option price modeling, is the calculation method commonly used to make the 409A. If the estimated common stock price is the target, and the 409A is the way to reach there, the OPM is the vessel used.
This calculating model works in a simple yet effective way: it divides the equity total worth between the levels of grants and stocks given (such as common, preferred, SAFE, etc.). The input is then subtracted by a Discount Lack of Marketability, which is determined by an educated valuation of the stock price taking into account the preferred stocks given. The final outcome is the number of an estimated common stock price that can be published and planned upon until it expires.
When will my 409A expire?
The 409A is valid for one year exactly, so every year should have a new evaluation at its doorsteps. That being said, there is one more case in which a 409A stops being valid and needs a do-over, that is any major financial event.
The majority of the time, a financial event that will force a new 409A valuation are a new funding round, a merger, an Exit, or an IPO. That being said, every field has its own significant game-changer events that might have an impact as well. In the medical-tech field, for example, an FDA approval is considered a huge milestone and will set the need for a redo of the 409A.
Another fearsome process that includes the need for an updated 409A valuation is the SBC expensing. When a company needs to acknowledge its stock options as a financial expense it will have to show an underline asset valuation that can be subtracted as part of the 409A.
Important 409A guidelines
It’s a must even when it’s not
You might not feel it in the first few years but avoiding the 409A isn't a good idea. On some occasions, when the company has just a handful of employees, technically the 409A can be avoided. This fact comes with a big warning sign: whenever you will be required to add an SBC expensing report to your financial report, you will have to apply 409A for each year that has passed without it. Realizing after half a decade that you need to come by five 409As at once, will be a headache to remember.
Save your 409As and they will save you
Even though you will probably apply a 409A every year and they might stack up as time goes by, don’t forget to save every related document. When a company is going through a due diligence process they are often required to present the change in common stock price over the years AKA comparison of the 409As bottom line. If you save the information with a dedicated data room, filling in the information requires no effort on your behalf. If you have a different way to store the information or even use hard copies it is highly recommended to put the minimal effort required and save all the 409As from the first year and so on.
Grants come second
Unfortunately, it is common for companies to sign grant letters to employees before they finish the 409A. In the US, 409A is mandatory but regardless, this valuation should be accomplished before any grant is offered to a new recruit. Signing a grant letter with a vague estimation of the stock price will create an exercising price that is unconnected to reality. The true numbers might make the exercising price overrated and therefore useless to the employee, or underrated and will hand leverage to other employees or potential recruits, in larger scales (9% total stocks or higher) it can also affect the stock value.
Expiration date or event
Keep track of your 409A and make sure it stays valid. Remember, the 409A might be valid for one year but it can also be expired after a major event. Each company has different events that might count as major so make sure you and the dedicated IRS are on the same page regarding what counts as a major event so you won't fall between the seats.
It takes time
Take into consideration the time it takes to create and apply the 409A. If you use an automated cap table the information will be fast and easy to come by so it should take no more than a week at the hands of an expert. If you use a spreadsheet cap table or any other version, the modeling might take longer, about two weeks or so. Give this time tables attention so you won't suffer from late fees or other problems in reports submissions and such.
Every year, a private company should file for a 409A valuation, which is recommended in general but when it comes to employing Americans it’s a must. The 409A is better known for its calculating method OPM, and is valid for one year or a major event in the company. Although it might not be mandatory, we recommend doing a 409A valuation every year, saving it, tracking it, and basing all grant-based compensation on it.
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