Many founders have questions about how to value stock options and around Section 409A. The following is a primer to help them.
Why is it important to accurately value stock options?
Under Section 409A of the Internal Revenue Code, private companies (such as tech startups) must determine the fair market value of their stock when they set stock option exercise prices (or “strike prices”) in order to avoid early income recognition by the optionee and the possibility of an additional 20% tax prior to option exercise. Since most companies want to avoid these tax problems for their option holders, it is important to value the options correctly.
How do we determine fair market value of private company stock?
Under IRS regulations, a company may use any reasonable valuation method so long as it takes into consideration all available information material to the valuation, including the following factors:
- the value of tangible and intangible assets;
- the present value of future cash-flows;
- the readily determinable market value of similar entities engaged in a substantially similar business; and
- other relevant factors such as control premiums or discounts for lack of marketability.
How do we know if our valuation method is “reasonable”?
There is no answer to this, unfortunately. However, there is a safe-harbor “presumption” by the IRS that the valuation is reasonable if:
- the valuation is determined by an independent appraisal as of a date no more than 12 months before the transaction date, or
- the valuation is of the “illiquid stock of a startup corporation” and is made in good faith, evidenced by a written report, and takes into account the relevant valuation factors described above. This report must written by someone with significant knowledge and experience or training in performing similar valuations.
What does that mean for my company?
If your company is post-VC funding, you will probably want to obtain an independent appraisal at least as often as you close a round of funding, and perhaps more often if the 12 month period has lapsed and you need to issue more options.
If your company is pre-VC funding but has seed funding or has significant assets, you may want to avail yourself of the written report safe harbor, though there are some costs associated with that approach. To avoid those costs you can have the board come to a reasonable valuation based on the above factors, but this valuation could be regarded by the IRS as unreasonable and tax penalties may apply.
If you are a pre-revenue startup with few assets and little funding, the board should do its best to calculate a reasonable value based on the factors above.
When should we re-value stock options?
You should value stock options every time you sell stock or grant stock options. You can use a previous valuation calculated in the last 12 months so long as there is not new information available that materially affects the value (for example, resolving litigation or receiving a patent).