409a Valuation for AI Companies

The value of shares your privately held firm may give as stock options to workers on a tax-free basis is calculated via a 409A valuation. For the sake of your firm and to prevent complications with the IRS, it is crucial to be comprehensive and correct while obtaining a 409A value.

To finish the appraisal, you’ll need to give yourself enough time to collect the necessary information and documents. If you decide to employ a company to do the appraisal for you, be sure to work with one that has a solid reputation in the industry. This article will give you an in-depth understanding of 409A valuation basics for AI companies.

409a valuation and AI companies

The Artificial Intelligence (AI) Industry was worth $96.10B in 2021, and it is expected to be worth $1,847.50B by 2030, growing at a CAGR of 32.9% between 2022 and 2030. While there are many branches of study within artificial intelligence, recent developments in machine learning in general and deep learning, in particular, are causing a sea change throughout the whole technology industry. To learn how these companies are valued, you must first understand how they work.

What are AI companies?

Artificial intelligence (AI) represents a broad field of computer science focused on developing intelligent computers that can accomplish activities that were traditionally thought to need human intellect. With the help of AI, computers can mimic and even surpass the cognitive powers of humans. Companies in every sector are investing in artificial intelligence as it becomes more and more integrated into daily life via developments like self-driving vehicles and the rise of smart companions like Siri and Alexa. There are various applications for AI technology, from chatbots and navigation software to wearable fitness monitoring devices. According to CB Insights, financing for AI firms in 2022 was $66.8 billion, more than twice the amount collected in 2020. AI companies are creating waves in several sectors due to their rapid adoption.

How do AI companies work?

Artificial intelligence (AI) systems can mimic many human cognitive abilities, including voice recognition, game playing, and pattern recognition. They master this ability by sifting through mountains of data in search of discernible patterns that may then inform their judgment. The learning process of AIs is often overseen by humans, who provide positive reinforcement for the right choices and negative reinforcement for the wrong ones. However, certain AI systems have been designed to learn on their own, maybe by repeatedly playing the same game until it figures out the strategy and wins. Uses for AI range from speeding up the creation of new vaccines to spotting signs of possible fraud automatically.

Why do AI companies offer stock options to employees?

Equity held by an employee is a sort of wealth that may be invested for future financial gain. Inadequate channels of communication, levels of mutual comprehension, and even access to money have all contributed to widening the gap between this promise and its actualization. The degree to which complexity and openness are obstacles varies among company types. This might make it difficult for a departing worker to ascertain whether or not the firm is financially stable. Employees in AI companies are motivated to remain with the firm for the long haul and put in extra effort when given stock options in the company. Employees who have the chance to hold ownership in the firm report feeling more invested in the company’s success.

Understand 409a valuation

To comply with Section 409a of the Internal Revenue Code, private companies must have an independent valuation performed on the date of issue to determine the FMV of the common stock (the fundamental security reserved primarily for founders and employees). This assessment follows the rules and regulations laid down in Internal Revenue Code section 409A.

To sum up, it’s vital to know the fair market value of the shares you’re offering or issuing to service providers, or else you might face hefty fines from the Internal Revenue Service. Therefore, an impartial 409A valuation might be useful if you intend to grant stock options.

Benefits of conducting 409A valuation for AI companies

To attract institutional investors, businesses often issue preferred stock in exchange for cash. Media reports of values reflect the after-money worth calculated using the preferred price rather than the common price.

In the event of a liquidation, creditors and holders of preferred stock have the right of first refusal to recover their money. The investor also gets a vote on major corporate decisions when they own preferred shares. These rights do not extend to common stockholders.

Payment to common shareholders will be contingent on the company’s value exceeding a certain level. The 409A valuation considers that a common shareholder, and especially a minority common shareholder, would not appreciate certain advantages.

It provides a valuation approach that accounts for the many features of preferred stock that are absent from ordinary shares. Preferred-share options and common-share options may vary significantly in value for an early-stage startup’s workforce.

Conducting 409a Valuation for AI Companies

A thorough understanding of your business is necessary before attempting a 409A assessment. The goal of a valuation is to determine the price at which one may expect to purchase one share of your company’s common stock. And several important aspects are considered to grasp this.

Step 1: Identify Key Assets

You’d have to reveal a lot about yourself and your business to get an estimate of its worth, including its history, finances, and more. If you’re getting your 409A valuation done soon, it’s helpful to know what data will be requested from you to prepare a proper analysis.

• Property algorithm – You’d have to be completely transparent about your business. It may take any shape. You may write an overview of your firm, a more in-depth explanation of your operations, or even a full-fledged presentation. The individual doing the appraisal would benefit from having this information since they would require to know all about your business. You must also provide all information about your company’s other financial characteristics, including its equity. If your firm has raised convertible debt or equity, you will need to present the relevant documentation and the investment conditions.
• Data sets – You must provide the analyst with full financial accounts for them to determine the worth of your firm following 409A valuation regulations. Your financial statements, cash flow statements, and balance sheets from the previous five years should be included here. If your company’s history dates back fewer than five years to its inception, you must provide complete financial statements covering the whole period. In addition, if your business anticipates any income in the next five years, you will need to present the analyst with projections for revenue, costs, and tax rate.
• Technology partnership – The capitalization table, or cap table, of your firm, is a technological aid that can significantly help in the appraisal of your business. To elaborate, the capitalization table is a record of the company’s investors and other owners, broken down by ownership stake, investment round, equity valuation, and dilution. You may learn who owns what percentage of the business and for what reasons by looking at the equity structure of the organization. Having a cap table prepared to provide to the analyst is a crucial element of acquiring the 409A value of your firm.

Step 2: Select the Right Valuation Method

During a 409A evaluation, a provider may choose to employ one of these three typical methodologies: the market approach, the income approach, or the asset approach. The 409a valuation methods are explained here.

• Market approach – Valuation firms frequently use the OPM backsolve approach while helping you get finance for your business. Investors are given preferred stock, but it’s reasonable to believe they paid the market price for their stake. As a result, we need to make certain corrections to the FMV to value common stock. To assess a company’s equity value, other market-based methods look at the financials of similar public firms, such as their sales, net revenue, and EBITDA.
• Income approach – Providers of business valuations often resort to the “simple income approach” when the target company has adequate sales and good cash flow. This approach to valuing businesses uses risk-adjusted projections of future cash flows as the basis for a firm’s worth.
• Asset approach – Companies in their infancy that have not yet obtained capital or generated revenue often use the asset method. By determining the net asset value, this strategy may provide a fair price to a business.

Step 3: Work with a Valuation Firm

A 409A valuation begins with determining the enterprise value. The fair market value of the common stock may be calculated by dividing the enterprise value by the number of equity classes. The third and last stage is to adjust the true market value downward by a percentage to account for the company’s lack of a public stock market listing.

• Choosing a valuation firm with experience in valuing AI companies – Your 409A appraisal should be conducted by a certified, independent valuation firm. A professional firm will work hard to guarantee that your value is fair, which the IRS will see as a “safe harbor” for your business.
• Collaborating with the valuation firm to ensure a thorough and accurate valuation – Your chosen valuation firm should have expertise with the value of firms in your industry, stage of development, and specific sectors. It’s also helpful if the company doing the work has established connections with major auditing companies. Keep in mind that the Internal Revenue Service (IRS) might still contest your value regardless of whether you’ve implemented all the necessary safeguards.

Valuation Considerations for Later-Stage & Pre-IPO AI Companies

As AI companies progress beyond initial funding rounds and approach later-stage or pre-IPO status, 409A valuation becomes complex. Several factors shape the valuation process for these advanced companies:

• Strong Financial Performance: Later-stage AI companies should show fast revenue growth and a clear path to making a profit. Investors look closely at sales numbers and how well the company keeps its customers.
• Market Comparables: For pre-IPO AI companies, appraisers benchmark against both public AI firms and high-growth tech companies recently entering public markets. Factors such as sector multipliers, trading comparables, and investor sentiment in public markets heavily influence valuation approaches.
• Unique Technology: AI companies with special technology, patents, or large data sets are usually valued higher. These assets make the business stand out.
• Complex Ownership: By this stage, companies may have many types of investors and shares. The valuation must factor in how all these different interests get paid in a major event, like an acquisition or IPO.
• Regulatory Readiness: Almost all public companies must follow strict rules. Their valuations must be solid and able to stand up to audits and government review.
• Market Position: How well the company competes in the market, its partnerships, and shifts in the AI industry can cause its value to change quickly.

Best Practices:

• Hire expert valuators with experience in AI and tech.
• Keep all financial and ownership records up-to-date and organized.
• Update your valuation after big company events or changes.
• Make sure your cap tables are clear and accurate.

Staying Compliant with 409a Valuation Requirements

A flourishing company’s future is in jeopardy if the Internal Revenue Service comes after it for violating Section 409A of the Tax Code. Despite the law’s complexity, the penalties are severe, and the IRS has no mechanism in place to negotiate settlements. The following are some considerations for private companies working toward 409A compliance.

• Understanding the Legal and Regulatory Landscape – Private companies may use the guidelines provided by Section 409A to determine the value of their private shares. In most cases (with a few exceptions), the IRS will treat a valuation as “reasonable” if it was performed by a non-related third party, creating a safe harbor. In the event of noncompliance with 409A, workers may incur tax penalties. So, it is crucial to stay compliant because of the following consequences:
  • According to the NQDC plan, workers are obligated to pay taxes on income and a 20% fine on any vested deferred amounts as of the final day of their vesting year, irrespective of whether payment takes place in subsequent years.
  • Employees are responsible for paying premium interest tax on unvested remuneration at a rate of 1% over the federal underpayment fine rate beginning on the vesting date.
  • If workers underreport their income, they may be subject to fines on top of any back pay they owe.
  • Workers will face penalties following state law.
• Conducting Regular Updates – A 409A refresh, or updated valuation, is required once every 12 months (or more often if a relevant event occurs). Significant occurrences that may trigger the need for an update are not limited to financial ones. The following factors urge a quick update:
  • A major shift in revenue, whether yearly recurring revenue or one-time money, is caused by a big, new, or lost contract.
  • Your company’s participation as a buyer or seller in a significant, finalized purchase.
  • A prospective buyer has provided your firm with a term sheet.
  • Joint venture with the potential to expand into new markets or increase profits.
  • Changes in the law can have a large impact on the size of your potential customer base.

Get a 409a valuation for your AI company from Eqvista!

Eqvista combines valuation expertise with trusted service, helping companies at every stage maximize their equity outcomes. With over $200B in Assets under Administration, Eqvista’s valuation reports are designed for all company stages, from early startups to unicorns and pre-IPO enterprises. 

Our certified experts deliver audit-ready, compliant reports for companies of any size, stage, or sector. No matter where your business is on its growth journey, Eqvista ensures your valuation is accurate, defensible, and ready for any audit or regulatory need.

Contact Eqvista today for a free consultation, and empower your AI company at any stage to succeed.