Both early stage start-ups and established companies are required to value shares of equity capital in order to comply with IRC 409A. This section of the Internal Revenue Code deals with deferred compensation, including stock options. Improperly priced stock options may force recipients to pay taxes on income they will never realize. Taxes are avoided when stock option strike price (exercise price) is set equal or higher than the fair market value of the company stock. IRC 409A valuations are performed to determine the value of the stock.
Having every option grant supported by a proper valuation is not practical for private companies. In deciding when to perform the next 409A valuation, consider the following:
- Timing of upcoming stock option grants. Naturally, there has to be stock option grants in order to do the valuation. The company can wait until it is ready for new grants. It may also cluster more grants around the date for which the valuation report is prepared
- Valuations are completed at least annually. While the shelf life of a 409A valuation is determined by significant changes in business operations, we do see companies stretch valuations as far as 12 months apart. Typically, those are relatively established start-ups that track to their business plan and don’t issue too many new stock options. In reality, many start-up valuations grow outdated after 6 months due to the ever unpredictable financial performance and broader market conditions
- Completed financing round triggers new valuation. New financing is often viewed as a value inflection point. According to the IRS and SEC, it is also a strong indicator of current common stock value. Companies routinely perform common stock valuations right after a new round is closed
- Significant changes in business operations, acquisitions, divestitures, explosive growth or loss of major customer often triggers a new valuation. It is frequently up to management to judge when the last valuation is no longer representative of the current business operations
- End of reporting period. The quality of the valuation analysis is closely related to the quality and completeness of available financial information. It is always better to have the valuation date coincide with the date when the clean set of financials is available for a valuation specialist to work with
A typical 409A valuation report is not suited to be used outside of narrowly defined compliance areas. However, such reports contain a great amount of information that can be repurposed for a multitude of strategic uses including tracking enterprise growth, developing equitable compensation policies, pricing secondary market transactions, and assessing strategic alternatives. Filed and forgotten, a 409A valuation report is a tremendous waste a wise business strategist could never afford.