Startup founders seeking their first infusion of non-”friends and family” capital will often seek out or entertain offers from investors in the form of a SAFE (“simple agreement for future equity”). Occasionally, I’m asked by startup founders considering a SAFE whether or not a “409” valuation is required before accepting such an investment.
What is a 409A?
No, we’re not talking about your and my favorite tub and shower cleaner. The short version is a 409A valuation (so named after the specific section of the Internal Revenue Code) is an independent, usually third-party appraisal of your company that, in turn, will end up setting a value on its shares.
Why would you want to do that? If your company is listed on a public stock exchange (e.g., NYSE, Nasdaq), the value of the company is pretty easy to figure out. In the old days, we’d open up The Wall Street Journal (the actual newspaper, not the website) but today you could easily type in your company’s ticker into Google and get the price per share of the company’s common stock.
When you’re a private company, particularly a new one, answering that question becomes a little more challenging. Any company that is also issuing equity compensation in the form of, say, stock options to key employees or consultants, needs to perform a 409A valuation. Since such equity awards are considered compensation to the employee, the Federal government wants to make sure that such compensation is subject to proper taxation. Just like you wouldn’t (or hopefully wouldn’t!) underreport wages or salary for your employees to the IRS, it’s a really bad idea to underreport compensation in the form of equity (or grants of options for equity) to employees, as well.
However, here’s where some tension comes into play. As a startup founder, you want to attract and retain the best most capable employees you can. This usually involves offering stock options with an exercise at an extremely attractive (translation: low) price, thereby sweetening the compensation offer to that prospective (or perhaps current, highly valued employee). However, if the exercise is set at anything less than the fair market value of the stock, there could be serious consequences.
Why does the 409A matter?
If the IRS later determines your the valuation you set in the award of stock or options does not meet regulations or just isn’t defensible, then all of the stock you granted to employees at the value you set would be subject to gross income tax. In addition, penalties of up to 20% on that amount could be levied on top of the back-taxes owed. Ouch.
This is where the 409A “safe harbor” comes into play. The 409A valuation is an assessment of the value of your business’ common stock and is basically required to set the exercise price for these stock options. For private companies, an independent 409A valuation is pretty much the only method to grant options (“qualified” or non-qualified) on a tax-free basis to your employees. It allows the company to rely on a valuation performed by a third-party valuation firm that meets the standards of the IRS.
Just as importantly, 409A compliance is routinely a part of the due diligence for every investor and acquirer of a company. A missing or indefensible 409A valuation could delay or, if bad enough, deter future outside investors like venture capital firms and, in extreme cases, render your company uninvestable.
409A valuations and your SAFE
So, bringing it back to the topic at hand; do companies who plan to raise funds on a SAFE, KISS (“keep it simple security”), or other, similar convertible instrument need a 409A valuation?
Ths short answer is No. A 409A valuation is not a prerequisite for raising capital through a convertible instrument such as a SAFE, KISS, or convertible debt. However, as made clear above, if you are (or are planning to) issue stock options to key employees, advisors, etc., it is strongly recommended that you order a 409A valuation, regardless of your fundraising status.
Bear in mind that, once you receive the valuation, the IRS will allow you to rely on that valuation for a 12-month period, so long as nothing occurs during that period that would constitute a “material” change in that valuation (e.g., a subsequent financing round at a higher price per share, an acquisition, etc.). Whenever in doubt, your company should get an updated valuation.
Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a startup, technology, and e-commerce law practice advising founders and management teams on company startup, corporate and technology transactions, e-commerce, as well as Internet privacy concerns. The firm serves corporate and individual clients throughout Arizona, the United States, and internationally. Our offices are conveniently located along the Camelback corridor in Phoenix’s financial district. For more information about our Company Startup practice, feel free to reach out using the contact form on the right or call us at (602) 222-5542 to schedule a meeting. Connect with Ben on LinkedIn or Avvo.