Following the Enron scandal of 2001, the government demanded corporations correctly value stock options granted to employees. Section 409A of the tax code requires startups to undertake regular audits to determine the value of the common shares they give out as options to their employees. A firm typically completes its first 409A valuation after raising its first round of funding, or any other sort of financing. However, many start-ups obtain funding from venture capitalists and angel funds by issuing convertible notes and SAFE notes instead of shares. When these corporations subsequently grant stock options to their employees, a common query arises, “Do SAFE and convertible notes require 409a?” In this article, we will understand its answer and the effects of debt instruments on 409a valuation.
Understand 409a valuation
The IRS began requiring firms planning to grant stock options to get a professional appraisal in 2005. The new standards were developed by the government to guarantee an accurate understanding of non-cash elements of employee remuneration, notably stock options. The 409A valuation is a procedure to assess the fair market value (FMV) of the common stocks of a company. The part of a company’s shares designated for employees and co-owners is known as common stock. The 409A valuation defines a company’s common stock’s base price and informs the cost at which workers can utilize their stock options. To effectively calculate the FMV of private business shares, 409A valuation needs an in-depth investigation of a variety of criteria. It is mostly done by a third-party expert in valuations.
Why is it necessary to get a 409a valuation?
The value of the common stocks of a private company isn’t public knowledge since it is not listed on a public stock market. Therefore, private firms that issue equity to workers on a tax-free basis need to get a 409A valuation. The IRS has published regulations requiring a “reasonable method” of calculating FMV at the time of issuance.
The “reasonable” valuation approach, frequently assessed by a third party, provides the corporation with a “safe harbor” as referred to by the IRS. A company can be levied large sums of tax upon the lack of proper valuation, and an unreasonable valuation can adjourn all employee remuneration in the current and preceding years, immediately taxing the subjects with an extra tax penalty of 20%.
How does a 409a valuation work for a private company?
Firms engage with an independent 409A valuator with experience in determining FMV for companies in their respective sector to create a presumption of “reasonableness”. Even if you have experience with a valuation business and all of the necessary skills, DO NOT perform a 409A valuation on your own since you are exposing yourself to significant risk and liabilities owing to the independence pre-requirement.
A 409A valuation is carried out following IRS requirements. The fair market value of a company’s privately owned shares is assessed using 409A valuation methodologies such as the Market Approach, Asset Approach, and Income Approach. It prevents possible hazards such as disparate treatment of stakeholders and noncompliance with IRS requirements. You will need to provide two types of information to the third-party valuation firm to determine FMV for your business; ie. quantitative data and qualitative data.
|Quantitative or Hard Data||Qualitative Data for Analysis|
|Past financial statements||The company's current level of development|
|The recent capitalization table||Financial forecasts and their key drivers, such as implied volatility and prospective funding|
|Board decks that give the most recent corporate updates||Expectations on the timing of anticipated liquidity occurrences|
An appraiser will utilize a “market” 409A valuation approach to calculate the FMV of a company’s common stock for the majority of early-stage enterprises. This means they will examine financial data from a set of analogous publicly listed firms, such as stock price, revenue, and EBITDA, i.e., earnings before interest, taxes, depreciation, and amortization.
A valuator takes into account the price of the company’s preferred stock—the shares granted to investors in exchange for specific benefits and rights—allowing them some control over the company’s direction. The valuator applies a discount rate to the business’s common stock to account for its illiquidity, based on how near the company is to experience a liquidity event.
Before granting stock options, the company’s executive board usually votes to approve the most recent 409A value. The 409A valuation must be carried out at least every 12 months for maintenance of the safe harbor.
Understand Convertible Notes and SAFE Notes
Startup attorneys devised convertible notes to allow businesses to acquire early capital without selling shares for a significant gain in a short period. A convertible note is a debt instrument with several variables and long paperwork. SAFE (simple agreement for future equity) is convertible security, which makes the process of obtaining seed funding simpler and more standard. However, unlike convertible notes, it is not a debt. Therefore, a convertible note contains a rate of interest rate and a rate of maturity, but a SAFE note, on the other hand, does not.
SAFE and convertible notes both change into stock in a future-priced equity round; however, a convertible note may be more complicated in terms of when/if/how it converts. Look at the comparison of convertible and SAFE notes below for a better understanding.
|Convertible Notes||Safe Notes|
|Interest Rates||2% to 8%. |
The length of time an investor holds the note affects his or her ownership stake.
|No interest rate, since SAFE notes are not debt - The length of time an investor holds the note does not affect his or her ownership stake.|
|Dilution and Valuation Cap||The valuation cap is negotiable in an uncapped convertible note and affects dilution in subsequent financing rounds.||The valuation cap is negotiable in uncapped SAFE Notes and affects subsequent financing rounds.|
|Maturity Date||Convertible notes typically mature 18 to 24 months following the closing date. Subsequent financing rounds typically take place before the maturity date and the notes must be repaid then.||No maturity rates- a benefit over convertible notes as they don’t need to be repaid.|
|Early Exits||In the case of buyouts or IPO, 2x payments are common. However, convertible notes aren't as standardized, so the payouts can be diverse.||SAFE notes give the investor the choice of converting to equity at the value cap or receiving a 1x dividend. Changes to these restrictions can be addressed using a side letter.|
|Structure Difference||Convertible notes are often structured as a single legal arrangement called the Note Purchasing Agreement (NPA), covering convertible note financing and all the terms. Each investor receives a promissory note detailing the date and investment value.||SAFE notes are often stand-alone deals offered to private investors, providing greater fundraising freedom.
|Terms||Terms include: ||Terms include:
409a For Different Types of Debt Instruments
The 409A guidelines don’t prescribe a single approach to debt securities consideration. The approach may differ in 409a for different types of debt instruments and the technique utilized, as well as the information and circumstances of the business. A 409A valuation is not required to raise capital via a convertible instrument like SAFE, KISS, or convertible notes. However, regardless of your fundraising status, if you intend to provide stock options to important employees, advisers, or others, it is strongly advised that you conduct a 409A valuation.
Valuation of Non-Convertible Debt
Only the subject company’s equity is valued in backsolve and backsolves with equity valuation techniques. Consequently, non-convertible debts are not explicitly included in company valuations and don’t affect the valuation’s outcome.
Non-convertible debt is deducted from the total value of the business computed using the applicable technique to get the value to be distributed through the firm’s cap structure under the Guideline Public Company (GPC) or Income (DCF) approach.
Valuation of Convertible Notes and SAFE Notes
A valuation cap on convertible notes or SAFE notes gives an indicator of a projected future value. This forecast is regarded as an estimate of the conversion value on the date of valuation. When a convertible note or SAFE note lacks a valuation cap, the future value is absent, and the convertible debt is classified as non-convertible debt.
For the valuation of convertible securities, valuation partners perform a hypothetical conversion of equities at the value cap of the assigned notes. By considering this conversion to allocated equity, the convertible note’s capacity to earn equity-like returns after repayment is displayed.
How Convertible Notes affect a 409A Valuation?
Convertible notes are popular among certain businesses since they are simple and affordable to produce. Some investors also favor it since it avoids the challenging topic of evaluating a fledgling firm in its early stages. However, if the notes are not correctly structured, the company can face difficulty securing the following round of funding, and it may result in a skewed value for common shares and stock options.
Tax and accounting regulations mandate valuation firms to examine the worth of the company suggested by recent financing. In these cases, convertible notes are treated as equity and not debt in valuation, with an assumption that the note will go through conversion and not repayment. This relates to both the issuing company’s and investors’ anticipation that the note will convert. The sole exception is if a company is sold before raising its Series A round, in which case the acquirer will return the note to secure investor approval.
A typically preferred stock valuation establishes a firm’s and common stock’s tangible present value. However, a convertible note does not give the same unambiguous valuation recommendations. Some notes have a cap value, which indicates an upper limit on the future value that cannot be surpassed. In such circumstances, the cap value must be considered as the value indication.
A Black-Scholes option model must be used to compute an implied value of the firm and the common stock – even though this work will also result in a proposed future value for the common stock. Despite considering a hefty discount for the absence of commercialization and a few other adjustments, the value of common stock and the spot price for future stock option issuance can sometimes be higher than the company’s true economic worth.
Get your 409A valuation with Eqvista!
While convertible securities can be beneficial when seeking seed funding, converting them into share ownership and including them in your 409A valuations can be complicated. Eqvista is a prominent provider of 409A valuations and can provide you with the most accurate valuation reports. We provide defensible 409A valuations for businesses of all sizes, in every industry. Our team comprises NACVA-certified professionals with the necessary credentials, expertise, and experience to provide you with the best service. Contact us today for more information on our 409A valuation service.