409a valuation – Guide for Founders
A 409A valuation is a third-party, independent appraisal of the fair market value of a private company’s common shares.
Many businesses use equity as a tool to raise funds and offer to employees, but it is not as simple as it may appear. When looking for investors, a startup’s valuation is done to evaluate its relative worth so that an investor can figure out what percentage of the company they should get in return. These assessments are significant, but they do not reflect the underlying value of a startup at the time of the transaction.
409a valuation for startups and businesses
Founders should keep in mind (at least) two alternative valuations throughout the life of a startup. The first is the value placed on the company by potential investors during a funding round. Second, the entrepreneur will need a 409A valuation from an independent third party when issuing stock options to workers. Every time the firm attempts to raise a new round of funding, founders and investors negotiate the company’s pre-money or post-money valuation. Instead, a 409A valuation uses a third-party assessor to determine the company’s fair market worth.
What is a 409a valuation? Why is it important for your business?
In reaction to the financial scandals of the early 2000s, the IRS enacted IRC Section 409A in 2005. As a result, Section 409A offers standards that private firms can employ to assess their valuation and, as a result, calculate their common stock’s fair market value (FMV). A 409a valuation ensures that the shares of the company are accurate and are measured and favor the employee rights. The protection of employee share is one aspect that makes them more valued as an integral part of the company.
Understand 409a valuation better and how does it work
At fair market value, a 409A is an impartial evaluation of a private company’s common stock, or equity reserved for founders and workers (FMV). The cost of purchasing a share is determined by this valuation. You can’t offer equity without first determining the value of each share. When a firm attempts to raise money from investors in an arm’s length negotiated transaction, a 409A valuation isn’t always an accurate reflection of its true value. Rather than common stock, most businesses issue preferred stock to cash investors.
- 409a valuation for a company/business – The fair market value (FMV) of a private company’s common stock is determined via a 409a valuation. An impartial appraisal determines the FMV. The equity reserved for founders and employees is known as common stock. A 409a valuation determines the cost of purchasing a share.
- 409a valuation for a startups – A 409A valuation is valid for 12 months or until a “material event” occurs, whichever comes first. Any event that has the potential to affect the stock price of your firm is considered a material event. Examples include substantial client losses and excellent financial outcomes. Getting funding from investors was almost certainly a material event as a company.
- 409a valuation for VCs – A 409A valuation, on the other hand, uses a third-party appraiser to evaluate the company’s fair market worth. The 409A valuation and pre/post-money valuation have a number of critical interactions that VCs should be aware of.
How does a 409a valuation differ by funding type?
Because investors bought Convertible Preferred shares, whereas the 409A valuation is based on the common stock, which is what the founders own and on which employees have options. The investors’ stock is far more valuable than the Common stock, share for share. This includes, among other things, the 409A valuation that is done for the company to issue shares to its employees, while the VCs undertake the post-money investment valuation. Although a 409A value differs from a pre-money or post-money valuation, it can nonetheless influence how an investor views a firm.
How to get a 409a valuation?
A 409A valuation is a third-party, independent appraisal of the fair market value of a private company’s common shares. The assessment conclusions are reported to the company’s board of directors in the form of a written valuation report, which is used to decide and set the price at which people can buy shares of the company’s common stock.
Requirements for getting 409a valuation
The IRS regulation IRC 409A states that stock options cannot be issued for less than their fair market value. So the Fair Market Value should ideally be evaluated by a third party who is not affiliated with the company. A 409A valuation is an impartial third-party valuation of your company’s common stock that is required in order to grant stock options to employees.
What does it cost to get a 409a valuation?
The cost of a 409a valuation will vary depending on whatever business or appraiser you use. However, based on a basic estimate, the price might range from $1,200 to $5,000.
Penalties for Noncompliance with 409A Rules
Employees must pay income tax and a 20% penalty on any deferred vested amounts under the NQDC plan as of the last day of the vesting year, even if payment happens in later years. If your NQDC arrangements are subject to 409A requirements and you have an operational failure, the IRS can tax and penalize all of your NQDC arrangements.
Why and how to choose the right 409a valuation provider?
A firm should have extensive experience, according to the IRS. This is defined by the IRS as having years of relevant company valuation experience. Companies should hire a valuation specialist with professional certifications, for example ABV, CPA, CVA. It’s also crucial to assess the reputation of the valuation firm. A straightforward Google search should suffice.
Choose the right 409a valuation service provider
The IRS says a firm should have extensive experience of relevant company valuation experience. One must look at these parameters to determine the valuation service provider:
- Look for the reputation and 409a valuation reviews – There are several methods for assessing a company’s reputation. They include media analysis, stakeholder surveys (customers, employees, investors, NGOs), focus groups, and public opinion polls, among others. You must be aware of the market reputation of the 409a valuation service provider, how many clients they have, the client experience, and the conversion rate.
- Check how much they charge – It is important to know the price of the valuation provider. It must be cost-effective as well as be able to provide quality and accurate reports. One can differentiate pricing by looking at the features, add-on services, and customer support.
- Comply with IRS guidelines – The IRS is in charge of enforcing the federal tax laws that Congress passes. The Internal Revenue Service (IRS) is in charge of enforcing federal tax laws enacted by Congress. Tax return processing, taxpayer assistance, and enforcement are the three core duties of the IRS.
- 409a valuation preparation time – In most cases, a 409A valuation takes less than a month to prepare. Unless you have a pressing need for a 409A valuation, most firms will complete one in a fair amount of time.
409a Valuation Report
A 409A valuation is an evaluation of a private company’s stock in order to prepare for the issuance of shares, and it includes all of the elements of the valuation process. To be clear, no particular “template” or sample 409a valuation report is employed. Every business has its own method of information sharing.
Also, the IRS does not provide any precise instructions as to what should be included in a startup 409A valuation report; there is no definitive template. However, there are a few key aspects that must be included in the report, such as the valuation, the methodologies utilized, and everything about the company that contributed to the firm’s value determination. It also considers the bigger picture of the environment and economy in which the firm operates to get a more accurate image of how much the company should be worth right now.
What should you look for in your 409a valuation report?
The FMV is the most important aspect of any appraisal (or strike price). We put it at the beginning of our report and then explain how we arrived at that figure. Keep in mind that third-party appraisers are obligated to come up with a value that is, in fact, fair while examining this figure. While a lower FMV may provide some benefits to you and your shareholders, you run the risk of the IRS deeming the value “grossly unreasonable”, rejecting it, and modifying the tax treatment of options issued under that valuation. If this happens, any employees who were given wrongly priced options may be subject to immediate taxation and penalties.
Understanding how a 409a valuation report is prepared (funded companies)
Most companies we encounter who need a 409a valuation do it for option pricing (setting the exercise price of their options, most likely ESOPs, after fundraising). For this they need a 409a valuation to comply with setting a correct exercise price.
With most VC-backed companies, their funding serves as a basis for the valuation method, ie. Backsolve and the 409a valuation also take on the pre-money valuation as taken through the round.
Let’s take an example to see what the 409a valuation would look like. Let’s say there’s a company called BioStart Inc., which just received a Series A funding round of $5 million dollars for $2.00 as share, off a pre-money valuation of $18 million.
This is a snapshot of their Cap Table and how the valuation was arrived at:
If we do some simple math, we can take the $5,200,000 capital committed by the Series A investors and divide it by their ownership percentage of 28.69% (excluding any rights).
Simply put, $5,200,000 / 28.69% = $18,123,456 or around $18 million at post money, or $15,523,456 pre money valuation. We can take this as a base for when doing the 409a valuation.
For Biostart Inc., we can see that the company has five different securities: Series A Preferred Stock, Seed Preferred Stock, Common Stock, Options @ $0.25, and their ESOP (Employee stock option plan) at 10% of the total shareholdings. The details of this will be crucial for the backsolve method later on. This method considers two main methods, a waterfall analysis and stock options pricing model, and calculates the value from the bottom-up on who receives value first and how much each receives.
With the information that BioStart Inc. predicts a probably exit within 4 years, here is how the breakdown would look like for each amount for a waterfall analysis:
- Breakpoint 1: At the first breakpoint, the Series A and Seed Preferred Stock shares a percentage of the total $6,450,000 invested in the company at 80.6% to 19.4%.
- Breakpoint 2: In the second breakpoint, the common stock would receive 100% of the value before any value goes to the option holders.
- Breakpoint 3: In the third breakpoint, the $0.25 strike price options get the value of the company and share with the common stockholders at 12.20% to 87.80%.
- Breakpoint 4: In the fourth breakpoint, the anticipated ESOP gets value and shares with the other option holders and common stock at a split of 73.24%, 10.17%, and 16.59%.
- Breakpoint 5: In the fifth breakpoint, the Seed Preferred Stock converted to common shares, as they would be gaining value per share over their $1.25.
- Breakpoint 6: In the fifth breakpoint, the Series A stock converted to common shares, as they would have a value of over $2.00 per share. This is the last tranche, so all equity classes would split the value according to their cap table ownership.
After running the calculations using the backsolve method, which involves using the Black Scholes Stock Option Pricing models, we calculate the hypothetical value of each Breakpoint to arrive at the $2.00 per share of the recent Series A funding.
From the backsolve, we find that the company is valued at $14,434,106, which is around 6.01% lower than our ballpark figure, which is quite close.
We can use this same method for finding the common share price (which becomes the option strike price) using the same calculations:
With the backsolve method, the common strike price (Pre-DLOM) is $1.42 according to the cap table structure.
As the company is still running at a loss and has other risks, a DLOM of 50% was applied to the common share price as:
$1.42 Common Share Price x 50% DLOM = $0.71 share price
This $0.71 would be set as the exercise price of the ESOP to be issued.
This price also represents around 35% of the $2.00 round ($2.00 / $0.71).
Some interesting facts and myths about 409a valuation
The common FMV should be kept low because it makes stock options appear more valuable to employees and recruits. Pursuing the lowest possible value at all costs, on the other hand, might have major ramifications for your business and employees. Despite the fact that the 409A valuation structure has become well-established, several early-day fallacies have survived. The four most popular are debunked in this section.
Maintain the lowest strike price at any cost
You cannot specify an option strike price that is lower than the 409A valuation’s computed FMV, but you can set one that is greater. Regulatory and tax authorities are often only concerned when the strike price is set lower than the 409A valuation supported: For the IRS, this would suggest that employees were given discounted (“in the money”) stock options that were taxable at the time of award; for the SEC, it would signal that the company was understating its stock compensation expense to artificially increase its profitability.
409a valuation creates a tax burden
Non-compliance with section 409A can have serious financial ramifications for your employees. Suppose the IRS gets involved and determines that your 409A valuation doesn’t fall under the safe harbor. In that case, all of the stock you granted to your employees under that FMV becomes part of their gross income (including interest owed) all at once in that year (not just the current taxable year, but any prior year). On stock options that vested prior to that tax year, the IRS might charge a penalty of up to 20%.
Have a negative influence on M&A and IPO
The buyer will look over your 409A valuations during M&A due diligence. In general, bad 409A procedures come across as sloppy, and they won’t help you set the tone for talks. If the buyer is unhappy with the 409A valuation(s), they can change the terms of the transaction so that they are not responsible for any financial burden associated with the mispriced options; they can demand that you indemnify them for the risk, or they can demand that you pay (or force your employees to pay) any associated penalties and taxes related to the affected option grants.
FAQs of Founders on 409A Valuations
For most companies, a 409A valuation can be a complicated process to understand. Many founders are aware of the importance of a 409A valuation, but they may not necessarily know all of the important details. We have helped answer some of the frequently asked questions from founders to help you understand more about the 409A valuation.
How is a 409A valuation determined?
Third-party evaluators and experts like Eqvista can be hired to determine the 409A valuation of the company. While there are various standardized methods that are followed to value equity, it is generally calculated on the basis of financial projections, cash flows, tangible and intangible assets of the company, future streams of revenue and profit and even by comparing it with the valuation of other similar public companies.
Thus, in the process of determining the 409A valuation, we consider all the available information that can help us corroborate the estimates. Get in touch with us to know more about the entire process.
Is the 409 valuation public?
A 409A valuation is determined to measure the fair market value of the common stocks only for privately held companies. So, to answer this question, no, it is not public. Startups have an imperative to protect their private information, as publicly available 409A valuations can subject them to trouble with the IRS.
However, in the process of calculating the 409A valuation, public companies can be used as a reference to help us determine the fair market value of the common stocks of a startup.
What is the difference between market value and fair market value?
A fair market value is the fundamental value of equity, based on present conditions that are considered to be free from any kind of market forces. While the market value is the estimation of the value of the equity if it was available to the public.
In fact, the market value has more to do with supply and demand in the market, and in comparison, 409A valuation determines the fair market value that is based on the financial projections, cash flows and tangible and intangible assets of the company.
Does 409A apply to consultants?
No, 409A valuation usually does not apply to consultants due to the fact that the 409A valuation is not applicable to the amount deferred under an arrangement between the company and the consultant. However, the consultant must be independent of the company. As a result, while conducting the 409A valuation, we need to note down the terms of their arrangement with the company.
How secondary trading can impact 409A valuation?
There is a significant probability that the 409A valuation is impacted by secondary trading. The factors that can impact 409A valuation include seller and buyer motivation, the similarity of securities that are sold, the volume of the transaction, information asymmetry, proximity of timing, or deal structure.
Hence, startups should know about the impact of secondary trading on 409A valuation and should be able to take appropriate measures. Eqvista’s team of experts is always available to guide startups through the entire process.
Why choose Eqvista as your expert valuation firm for 409a valuation?
Eqvista offers high-quality 409A valuations for all companies. Getting a 409A valuation is important when your company undergoes a material event like M&As, new funding rounds, etc. Companies are highly recommended to have their 409A valuation done to avoid tax penalties and audits. Contact us to learn more about our 409a valuation service and how Eqvista can help you.