When determining the value of a public company stock, you can go online and quickly see the price of shares on the open market. However, that isn’t possible with private companies. Private companies must first determine the “fair market value” (FMV) of their common stock with a 409A valuation.
Fair market value is the accepted current value of one share of a private company’s common stock. It represents what the stock would be worth on the open market. However, this is not the same thing as “post-money valuation”, which is the market value for the entire company.
How to determine a stock’s fair market value
409A valuations determine the fair market value of your common stock. In other words, they control the price employees, contractors, and anyone else who gets common stock needs to pay to purchase their stock options—this is called the strike price. The strike price must be equal or greater than the FMV stated in the 409A valuation.
When valuing your company, 409A providers usually look at a few different factors:
- How much your assets are worth
- The present value of your future cash flows
- How much common stock is worth at similar companies
- How much equity your company has in other similar businesses or industries.
Companies need a new 409A valuation every year or each time a material event (such as a new funding round, acquisition or merger) occurs.
Why you need to get fair market value right
When establishing the FMV, third party appraisers are obligated to come up with a number that is, in fact, fair. While you and your shareholders may see certain benefits from a lower FMV, the IRS may reject valuations it finds “grossly unreasonable.” If the IRS rejects the valuation, that would revise the tax treatment of options issued under that valuation. And, If this happens, any employees who received incorrectly priced options could be taxed on those options immediately and may have to pay penalties.
While companies may be able to value their own stock in their early stages, if they want the FMV to be eligible for the option tax treatment of 409A protected under IRS safe harbor, they must get a 409A issued from an independent appraiser. The safe harbor ensures that the IRS will accept the FMV unless it is deemed to be “grossly unreasonable.”
Using Carta for your 409A valuation
At Carta, we offer 409A valuations with all of our paid plans and provide free 409A refreshes after material events. We’re the leading provider of 409A valuations in the country, with over 5,000 valuations delivered every year. With a Carta 409A valuation, you can take advantage of IRS safe harbor when you issue options to employees and advisors. We stand by our valuations and will support you in audits.
DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta, Inc. (“Carta”). This communication is not to be construed as legal, financial or tax advice and is for informational purposes only. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.
