When do I need a 409A valuation?

As a reminder (or if it's your first time hearing this), a 409A valuation is an independent appraisal that determines the fair market value (FMV) of a startup’s common stock. It helps ensure compliance with IRS regulations and provides a safe harbor against severe tax penalties. Knowing when to get a 409A valuation is critical to avoid such penalties, which can include accrued interest and an additional 20% tax.

Here are three key scenarios when you should talk to your legal, financial and tax professionals about getting a 409A valuation:

Offering Deferred Compensation

Under the IRS code, deferred compensation refers to compensation earned in one tax year, but paid in a future tax year. This commonly arises for startups when issuing stock options or other equity awards that are subject vesting. However, it takes many forms and can arise from situations such as a bonus deferral or a severance agreement with payouts over time.

After a Material Event

IRS regulations also require a 409A valuation if your startup is offering deferred compensation and the business experiences a “material event” that affects the stock’s FMV. The IRS leaves “material event” largely undefined and ambiguous, but includes macroeconomic issues completely outside of your startup’s control such as a pandemic, war or recession, as well as developments specific to your startup such as undergoing a major financing round, receiving a term sheet, significant revenue changes from gaining or losing a customer, or entering into a strategic partnership or acquisition.

When determining if a material event has occurred, we advise erring on the side of caution. Even raising a couple hundred thousand dollars on SAFEs or signing a contract that changes revenue trajectory by 10% or more could constitute a material event and trigger the need for a 409A valuation.

After 12 Months

If no material event occurs from your last 409A valuation, then IRS rules require a new 409A valuation every 12 months as a baseline update.

Why This Matters

While an IRS audit is unlikely for an early-stage startup, a 409A valuation remains essential. Potential investors want confidence that the company and its employees have safe harbor protection from the severe tax penalties. And as your startup grows, the risk of an IRS audit increases, amplifying the impact of any early-stage missteps with taxes. Remember that the ambiguity of the 409A valuation requirement is a feature, not a bug, to provide the IRS with flexibility in preventing abuse of deferred compensation arrangement. So when you are in doubt, consult your legal and tax professional to discuss, stay compliant, and avoid surprises.