employee equity compensation in tech startups
The 409A valuation (also called fair market value, or simply the 409A) is the valuation of one private company common share for tax purposes.
When paying taxes on your equity compensation, the amount you owe is based on the 409A.
The 409A is re-evaluated at least every year, and additionally whenever something big (like a new investment round) happens. Generally speaking, as your company grows more successful, the 409A increases.
If you have stock options and want to get the full picture of how they work, read our Stock Option Starter Guide.
Ask your employer for the current 409A.
The 409A is determined by an independent valuation provider.
Every company that offers equity to their employees is required by law to get a 409A valuation. Re-valuations are required at least yearly, or whenever there is a material event (such as a new investment round) that may impact the company’s valuation.
Generally speaking, as your company grows more successful, the 409A increases.
The independent valuator determines the 409A using one of several approaches. They may analyze comparable private and public companies, analyze the company’s free cash flow or take the company’s tangible and intangible assets as the basis for their valuation.
An upcoming 409A change is important to know because it influences your upfront costs of exercising stock options: if it increases, your upfront costs increase with it.
It’s a good idea to ask your company when they expect a re-evaluation so that you can plan for your exercise. Note, however, that they can never be 100% sure: a material event may happen unexpectedly.
The 409A valuation impacts employees in two ways.
For example, let’s say you’re granted options with a strike price of $1 when the 409A is also $1. If you immediately exercise (assuming your company allows early exercising), you wouldn’t need to pay taxes, as the difference is $0.
If on the other hand you exercise after the 409A is set to $3 at some point in the future, then per option you exercise, you pay tax over the $2 difference.
The 409A name comes from IRS Section 409A. This section in the United States tax code addresses how Americans are taxed on deferred compensation such as stock options and equity grants.