409A Valuation Vs. Fair Market Price (FMV): What's The Difference?

When releasing stock alternatives or structuring compensation plans, lots of creators come across 2 important-yet often misunderstood-terms: 409A Valuation and Fair Market Value (FMV). At a glimpse, they might seem interchangeable. In practice, they serve different legal, tax, and functional functions. Understanding the difference in between 409A vs FMV is vital for private companies, specifically startups, that desire to stay compliant and competitive.

In this guide, we'll break down:

- What is a 409A valuation?
- What is Fair Market Price (FMV)?
- How the IRS views each
- The relationship in between 409A and FMV
- Why the difference matters for equity compensation
- Common misunderstandings and mistakes
- Best practices for start-ups

Let's dive in.

What Is a 409A Valuation?

A 409A appraisal is a formal, independent appraisal used to identify the reasonable market price of a private business's typical stock. It gets its name from Section 409A of the Internal Revenue Code, which governs non-qualified delayed settlement.

Startups typically utilize a 409A appraisal to set the strike cost of stock alternatives provided to workers. Legally, the strike rate need to not be lower than the FMV of the underlying typical stock on the grant date. A 409A appraisal helps guarantee compliance with this guideline.

For companies using Mantle's cap table management platform, the 409A appraisal can be structured for easy tracking and compliance.

Key Features of a 409A Valuation:

- Conducted by a third-party assessment firm
- Required for independently held business providing stock alternatives
- Must be updated every 12 months or after a product occasion (e.g., fundraising, acquisition deal).
- Provides a "safe harbor" to protect companies and employees from IRS penalties

To learn more on 409A appraisals, take a look at our guide.

What Is Fair Market Price (FMV)?

Fair Market Value (FMV) is a broader monetary idea specified by the IRS as:

" The price at which the residential or commercial property would change hands in between a willing purchaser and a prepared seller, neither being under any obsession to purchase or to offer and both having reasonable knowledge of appropriate realities."

FMV can be used in numerous contexts:

- Sale of company shares or assets.
- Gifting of equity for estate or tax preparation.
- Purchase of stock options.
- Mergers and acquisitions

While a 409A appraisal intends to establish FMV for compliance, not all FMV assessments meet the standards needed under 409A.

409A Valuations vs. Fair Market Price: Key Differences

Here's how 409A evaluations vs. reasonable market worth compare throughout key locations:

For a more detailed appearance at compliance and valuation threats, examine out our post on 409A evaluation guide.

How the IRS Views 409A Valuations vs. FMV

The IRS uses 409A assessments particularly to regulate deferred compensation, such as stock options. If a company concerns options with a strike rate listed below FMV without a vlid 409A valuation, the comployee might face:

- Immediate income tax on the delayed compensation.
- An extra 20% charge tax.
- Interest charges on unsettled taxes

Safe Harbor Protection

A compliant 409A appraisal offers a safe harbor, shifting the burden of evidence to the IRS. To quality:

- The evaluation must be performed by a certified independent appraiser.
- It must be less than 12 months old.
- There should have been no material changes impacting the appraisal.

FMV, on the other hand, is a general concept used by the IRS in many tax-related scenarios-not just equity settlement. which transfers of residential or commercial property are evaluated for tax purposes.

Why the Distinction Between 409A and FMV Matters

Understanding 409A valuations vs. reasonable market value is crucial for:

- Issuing equity grants properly.
- Avoiding expensive IRS penalties.
- Getting ready for audits, due diligence, and acquisitions.
- Planning tax strategies for executives and workers

A typical mistake is presuming the FMV equates to the current preferred stock rate. However, preferred shares typically bring liquidation choices and investor securities, meaning they deserve more than common stock.

A 409A Valuation represent:

- Capital structure (typical vs. favored shares).
- Discount for absence of marketability (DLOM).
- Financial efficiency and market comparables.
- Risk profile and business stage

Practical Example: VC Round vs. 409A Valuation

Let's state your start-up raises a Series A round at $10/share for favored stock. That evaluation consists of investor rights that typical shares do not have.

An appropriate 409A evaluation might evaluate the FMV of common stock at $2.50/ share, showing:

- Illiquidity of personal shares.
- Subordination to favored stock.
- Risk profile for early-stage companies

Issuing alternatives at $10/share rather of $2.50/ share might:

- Trigger IRS examination.
- Deter employees from working out choices.
- Overstate compensation expenditure on your books

When to Update Your 409A Valuation

To preserve compliance, update your 409A assessment:

At least every 12 months.
After any material occasion, such as: - New funding round.
- Acquisition offer.
- Major business pivot.
- Large earnings modification

Failing to update your evaluation can invalidate your safe harbor status and expose the business to tax and legal danger.

You can discover more information on when to upgrade your 409A valuation here.

Common Mistakes Companies Make

Relying on Internal FMV Estimates: These typically do not satisfy safe harbor requirements and typically lack documentation.
Confusing Preferred and Common Stock Valuation: Valuing common stock at the very same cost as preferred can result in overvaluation and compliance problems.
Skipping Updates After Major Events: Material changes like fundraising rounds should trigger an assessment update.
Granting Options Without a Valid 409A: Retroactive rates can lead to charges and taxable earnings for workers.
Best Practices for Managing 409A Valuations and FMV

- Work with a reputable third-party evaluation firm.
- Schedule evaluation updates annually.
- Update after material events.
- Keep detailed records of all grants and valuations.
- Educate staff members on how stock choices and FMV work

Final Thoughts: 409A Valuations vs. Fair Market Price

While they're closely related, 409A valuations and reasonable market price are not interchangeable. FMV is the wider monetary concept, while a 409A evaluation is a particular, defensible technique to identify FMV for providing stock options in private business.

For startups, the safest path is to treat 409A valuations as a legal and compliance requirement, and FMV as the foundation of sound equity preparation. Understanding and handling both guarantees you stay IRS-compliant, draw in leading talent, and keep transparency with financiers and workers.

Need assist with your next 409A valuation or cap table management? See how Mantle can help simplify compliance and equity management for you and your legal group.