Do I need a 409A valuation for my company?
A 409A valuation sets the fair market value (FMV) of a company's common stock and this price is used as the strike price for option grants. If a company is not in compliance with Section 409A, there may be severe penalties, including that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, and penalty interest.
As your company grows, if you intend to issue option grants, you will eventually need a 409A valuation .
The question is, "When in my company's life cycle will I need to purchase a 409A valuation?" The decision of when it is time to buy a 409A valuation is dependent on multiple factors.
For example, imagine a start-up with two founders and $100K in funding. The company is hiring their very first employee and wants to issue options as equity compensation. Founders need to weigh the expense of being in compliance with 409A regulations with making payroll. Early stage companies will typically discuss the best way to move forward with their law firm, and the law firm and board may decide to use a board determined strike price for the option grant instead of obtaining a 409A valuation.
As another example, imagine a start-up with $500K in convertible notes, and multiple employees. The founders are starting to plan for a Series Seed priced round, and would like to issue paper option grants for the early employees that took the plunge to join a risky start-up. If the company obtains a 409A valuation, the company will be compliant with IRS regulations, and set a strike for option grants ahead of the Series Seed. If the company continues to grow and be financially successful, the 409A valuation will provide "safe harbor" for the company and early employees, and minimize potential future audit expenses, taxes, and penalties.
Determining when it is the right time to buy a 409A valuation depends on multiple factors, especially for early-stage ventures. Be sure to discuss with your board and law firm whether or not it is the right time for a 409A valuation for your company.