409a Valuation for Crypto Companies
Here is what you need to know about 409a valuation for crypto companies.
409A valuation and compliance are not the most exciting parts of being a founder, but they are critical parts of the long-term success of a company. And just so you know, every kind of company needs to get itself valued so that it satisfies tax compliances set by the government. This is especially true where the founders share equity with their staff or take on outside investment.
This leads to issues as the IRS needs a way to regulate these companies for tax purposes. And since they are very different from normal companies, not everyone can value them the right way. In fact, some do not understand how to get cryptocurrency companies valued. That is where Eqvista comes into the picture. Our team is equipped with the needed experience, knowledge, and understanding in valuing crypto companies. Here is what you need to know about 409a valuation for crypto companies.
Crypto Company 409a valuations by the numbers
Here is a summary of the 409a valuations for crypto companies performed by Eqvista. These average figures were obtained from the public markets, private markets, and our 409a valuations.
*Most 409a valuations for Crypto companies do not use EBITDA multiples
409A Valuation for Crypto Companies
Just like any other company, all types of crypto companies need to get their 409A valuations done as per the IRS compliance rules. This is essential when the company shareholders file their 1040s, as their tax obligations may go beyond the number of tokens they hold. Let us first understand a bit about the 409A valuation.
Understanding 409a Valuation & It’s Importance
Having a private company means that your company’s value isn’t set by the market, like public companies. In fact, a private company’s share price is derived by the firm’s overall value. That is where the IRS Section 409A comes in. Section 409A of the IRC is a rule that states the company has to get an appraiser to find the company’s fair market value (FMV) using approved methods. The FMV determined is of the company’s common stock or the stock reserved for employees and founders. Basically, the valuation determines the cost to purchase a share in the company.
Put simply, a company cannot just offer equity without knowing the value of the shares. And to know the value of the share, you will need a 409A valuation done. Why follow the rule? If the IRS audits your company and finds the shares and tax filings are not set as per FMV, there would be adverse tax consequences for not only the company, but also for the shareholders.
- The employees and shareholders would be taxed on the options they received immediately.
- The employees and shareholders would have to pay an additional 20% of the value of their option grants and might have to pay other penalties as well.
When the valuation is conducted by an independent or unaffiliated party, it establishes a safe harbor status. This means that the value determined is considered reasonable by the IRS, and the responsibility shifts onto the IRS to prove the FMV calculated is mispriced (like innocent until proven guilty). Otherwise without safe harbour status, the company must prove to the IRS that the share price it calculated is accurate.
Factors that influence your company valuation
Many factors affect the valuation of a company, including:
- Industry demand: The industry in which the company belongs is a huge factor, and if the company operates in a “hot” industry (where there are greater demands to make investments), the value of the company would be higher than a company of the same size and stage in another industry.
- Market size: The size of the market also matters, where the larger the market size, the bigger the potential upside of an investment. Moreover, the market demand also matters since the investment chances reduce if the company is in a saturated market.
- Development stage: A startup would obviously have a lower valuation as compared to a medium-sized company.
- Future financing: The number of rounds that the company needs to reach an exit point is also another important factor.
- Traction: If the company has evidence that it is gaining a lot of traction and high growth rates, this will lead to a higher valuation.
- Unit economics: Being a new company, it is unlikely to become highly profitable instantly. Showing good unit economics for the service or product would display how profitable you might be in the future and would simultaneously increase the valuation.
- Investor demand: The higher the investor demand to get in on the deal, the higher the company’s value.
- General economy: When the economy isn’t good, the value would be low, and vice-versa.
- Comparable companies: All the comparable companies and industries are considered when obtaining the company’s value.
Do crypto companies require a 409a valuation?
Blockchain is a revolutionary technology that has been used to power virtual currencies like cryptocurrency (also known as virtual tokens). Since it is highly popular now, companies that started raising money using “initial coin offerings” (ICOs) and using tokens to compensate and incentivize founders, directors, employees, and consultants. Due to this, the question arises on how these tokens would be viewed and regulated by the IRS and the SEC. Other companies trade in cryptocurrency or other crypto-related services and need to find the value of their company by non-traditional means and methods.
That is why the IRS has also implemented the rule of getting the 409A valuation performed for the crypto companies just as it would be for any other company.
409a valuation for Crypto companies
409A valuation also applies to crypto companies. Valuing crypto companies takes place just like any other company; that is when the company wants to issue employee deferred compensation. And as per the IRS rule, the company would need to get the 409A valuation for their cryptocurrency company. A company and token valuation is a process to determine the fair value of the crypto-token. The valuation is performed for compliance, tax purposes, and strategic purposes. It is mostly done before the issuance of a token-based deferred compensation.
Performing the 409A valuation for crypto companies is very different from performing the valuation for other companies. And not every evaluator can get the right results. At Eqvista, our team understands all the crypto space’s intricacies, including the technical and legal relationships between the companies and their foundations or related entities, the types of crypto companies, the several validation methodologies behind transactions, and the unique market position that crypto tokens operate in.
How Does Crypto Work?
Cryptocurrency is a decentralized finance, or DeFi. This means they are neither issued or supported by a central authority. Instead, they’re distributed across a computer network. Cryptocurrencies can be purchased and sold on exchanges and held in ‘wallets’, and can be used to buy and sell items as well as to store value over time.
What is Cryptocurrency?
A cryptocurrency, often known as crypto, is a digital and decentralized form of currency. Because cryptocurrency is neither backed by or convertible into a commodity, it is not classified as a fiat currency. Validators keep the cryptocurrency running by confirming and recording transactions on the blockchain, which is a decentralized database that is shared among computer network nodes. The blockchain is well known for their critical role in keeping a secure and decentralized record of transactions in cryptocurrency systems like Bitcoin.
Types of Cryptocurrency
There are many different kinds of cryptocurrency, but there are a few that are major players in the industry. Here are some of the biggest cryptocurrency in the market:
- Bitcoin (BTC) – Bitcoin is the world’s very first cryptocurrency that was launched in January 2009. Created by a pseudonymous programmer by the name of “Satoshi Nakamoto”, Bitcoin has emerged as the biggest player in the crypto space. There is a fixed supply of 21 million bitcoin, and no more bitcoin can be created or destroyed. As of September 2021, El Salvador is the first country ever to formally make Bitcoin a legal tender.
- Ethereum (ETH) – Ethereum was proposed by Russian-Canadian programmer Vitalik Buterin in 2013, and was released in July 2015. What makes Ethereum stand out is the availability of smart contracts that allows developers to create their own decentralized applications, or DApps. Ethereum is the second largest cryptocurrency after Bitcoin, and it is commonly used to pay for transaction fees called ‘gas fees’.
- Binance Coin (BNB) – Binance Coin is a utility cryptocurrency that may be used to pay for trading costs on the Binance Exchange. By market capitalization, it is the third-largest cryptocurrency. Those that use the token to pay for the exchange can trade at a reduced rate. Their blockchain, known as BNB Smart Chain (BSC), also serves as the foundation for Binance’s centralized exchange.
- Tether (USDT) – Tether is one of the first and most popular stablecoins, which try to decrease volatility by pegging their market value to a currency or other external reference point. Tether and other stable coins (such as USDC or DAI) seek to smooth out price variations to attract consumers who might otherwise be wary of digital currencies, especially significant ones like Bitcoin. The price of Tether is directly linked to the price of the US dollar, which enables users to make transfers from other cryptocurrencies to US dollars in a fraction of the time it takes to convert to regular currency.
What Can You Do with Crypto?
More and more businesses use cryptocurrency for investment, operational and transactional purposes. Cryptocurrency offers a number of advantages that fiat currency does not. Here are some examples of what you can do with cryptocurrency:
- Form of Startup Funding – Raising funds for new startups has been made easier with the rise of cryptocurrency. Aside from receiving funding from venture capitals and angel investors, startup founders can now use crypto as a form of crowdfunding as well.
- Peer-to-Peer Trading – You can trade cryptocurrencies with other people as long as both parties have a crypto wallet. What makes crypto trading unique is the transparency of the transactions since they are recorded on the blockchain. Transactions are also nearly impossible to change since the blockchain has almost zero chances of being hacked, or have human or software error.
- Used for purchases – Bitcoin had little utility as a method of payment to merchants at first. Now, several merchants around the world, including restaurants, airplanes, jewelers, and applications, have started to accept cryptocurrency as a valid payment method over time. Some items that can be bought using crypto are: insurance, luxury items, event tickets, and even consumer staples.
- NFTs (Non-fungible Tokens) – NFTs are a fairly new technology that is being explored and adopted by multiple A-list companies like Facebook/Meta, Twitter, etc. NFTs can be used for investments, collections (e.g. art, music), but it is commonly used to sell digital art nowadays.
Where to keep/store crypto?
You can store and hold cryptocurrencies in wallets, and there are different types. Some can be a physical form, some are kept online and digitally. Here are the most common types of crypto wallets available:
- Custodial Wallet – The easiest and most popular way to set up a crypto wallet is creating a custodial wallet. Similar to keeping a savings account in a bank, custodial wallets are tied to crypto exchanges (such as Coinbase and Binance). If anything were to happen to your wallet, say if you got hacked or something happened to your funds, the company can help you.
- Cold Wallet – Cold wallets allow users to store cryptocurrency offline. Cold wallets can take several physical forms (some of which resemble USB sticks). One example of a cold wallet is Ledger. Cold wallets are also called hardware wallets since they take on a physical form.
- Hot Wallet – A hot wallet is a software for storing cryptocurrency. Hot wallets are normally offered as desktop and mobile apps, however, web-based hot wallets are also available.
A cryptocurrency exchange allows users to buy, sell and trade cryptocurrencies for other assets (i.e. digital and fiat currencies). Crypto exchanges act as an intermediary between buyers and sellers. There are two types of cryptocurrency exchanges: centralized and decentralized.
- Centralized Exchange – This is the most common type of cryptocurrency exchange. Centralized exchanges function as a middleman or intermediary, facilitating transactions between buyers and sellers. Some examples of centralized exchanges are Coinbase, Kraken, Gemini, and Binance.
- Decentralized Exchange – With decentralized exchanges, peer-to-peer transactions can be executed without the need for an intermediary. However, trading fiat currencies for cryptocurrency is not possible on a decentralized exchange. Some well-known decentralized exchanges are Uniswap, PancakeSwap, and Sushswap.
How does equity work in Crypto Currency companies?
Let us now understand equity and cryptocurrency. When a company completes an ICO, it is selling a coin or a “token” to the public. Unlike the IPO, an ICO does not necessarily grant the token purchaser the same ownership rights that a shareholder is entitled to under the federal securities laws. And today, there are basically two kinds of issuances of crypto tokens: utility tokens and security tokens.
Security tokens are intended to be treated as investment vehicles and have to comply with the regulatory requirements. On the other hand, the utility tokens are designed to offer token holders access to the company’s services or products or serve a specific function on its blockchain. In many cases, companies are structured as C-corporations with preferred and common shareholders while having utility tokens trading an open exchange. This introduces a new consideration for startups that have issued utility tokens and how the token value impacts their 409A valuation. In fact, there are a lot of such challenges that come into question when valuing crypto companies.
Challenges of valuing crypto companies
As mentioned above, there are a lot of challenges as it is with any form of innovation. The IRS has released guidance indicating that tokens issued to individuals in exchange for services would normally be treated as compensation subject to income and payroll taxes under the IRC and would be reported on the Form W-2. Hence, employers who are issuing tokens to employees and other service providers have to first get the fair market value of the tokens to then properly report it.
Nonetheless, the IRS does not treat tokens as currency but as a property. Due to this, based on the kind of award, the recipient might have to file an election with the IRS to tax the award at the time of the grant (an “83(b) election”). But just be clear, this can be very risky if the tokens are later forfeited or fall in value. Moreover, the IRS has not issued guidance on when token options are subject to Section 409A of the IRC. So, the issuers would have to assume that token options are subject to Section 409A and get the 409A valuation done. It is better to have it done than pay for the hefty penalties and lose your employees and/or shareholders.
409a valuation based on crypto company Stage
Just like every other company, the crypto companies also have different stages. And for every stage, the value of the currency is different and is affected by a lot of factors as well (most of which have been mentioned above). For valuing crypto companies, it is important to hire the company that has the right experience and knowledge regarding token valuation.
Eqvista has a team of professionals that hold the required certificates and have both the experience and knowledge to determine the 409A valuation for the crypto companies based on the stage of the cryptocurrency. We have created 409A valuation reports for many such clients and they have successfully gained safe harbor status. This has helped them stay away from the IRS audit and any penalties.
Get 409a Valuation for Your Crypto Company
Finally, if you have a cryptocurrency company and have not yet got your 409A valuation done and are about to go through a major event or issue currencies to employees, then we can help you. Regardless of the stage your company is in, we will offer you the most accurate cryptocurrency value for your company.
Even though you may be operating in the risky industry of crypto, there’s no need to risk your company valuation and taxes. Better to engage an independent valuation appraiser, like Eqvista, to get a company valuation for your share price.
Contact us today to discuss more about your crypto company and how to get your 409a valuation started!