409A Valuations4 min read

I knew my course in introductory finance would one day pay off.

In terms of the administrative and regulatory overhead of running a startup, the need to conduct a 409A valuation makes for an interesting discussion.

The concept of this IRS rule is simple: a company must value its shares fairly and price its options accordingly. Options issued below the fair market value create a taxable event as value is conferred upon the recipient at the time of grant. And, if the appropriate taxes are not paid at that time, the company can later be subject to a stiff penalty while the employee would be responsible for taxes and interest. Not fun.

The subject of 409A valuations is intimidating. If you’re thinking about doing it yourself, it is easy to get caught up in the various frameworks and techniques: Black-Scholes, lattice, Monte Carlo, Probability-Weighted Expected Return Model, market-based, income-based. Furthermore, the literature and guidance online highlight the dangers of making a mistake — a failed IRS audit resulting in draconian fines and terrible tax consequences for employees who were granted options.

So, surely it makes sense to drop up to $25k for a qualified, experienced, outside professional to conduct the evaluation, thereby automatically creating a safe-harbor protection against penalty?

Not really.

Here’s the thing: much of the literature online is authored by firms trying to sell their expertise. With one exception, the entirety of the first page of Google results for the search term “409A Valuation” is comprised of firms attempting to sow fear, uncertainty, and doubt in order to peddle their services. Their message: this is a scary process, but, fortunately, qualified experts can help.

Here’s an interesting tidbit that isn’t shared so widely by these vendors:

In the decade-long history of the 409A rule, there hasn’t been a single instance of an audit by the IRS on a startup’s option valuation.

What are the odds that you’re going to be the first — particularly if you act reasonably and in good faith?

Here’s another interesting fact:

Provided that a valuation was done by a “qualified individual”, the burden falls on the IRS to prove that the valuation was “grossly unfair.”

So…. in the highly unlikely event the IRS decides that your startup will be the first that it takes enforcement action against, so long as you had an appropriate level of competence to perform an evaluation, it’s still an uphill battle for the IRS to prevail.

From my standpoint, I love the 409A valuation as it has allowed me to dust off one of my favorite parts of my education: options pricing theory. I am always waiting for occasions to show that learning the Capital Asset Pricing Model and efficient frontier hypothesis was going to pay off.