Best 409A valuation method for different startup stages

To comply with tax laws, you must get a 409A valuation when you issue stock-based compensation like employee stock ownership plans (ESOPs). However, there are multiple 409A valuation methods. Each has its advantages and drawbacks. One of them is suitable for early-stage startups who want to save costs but cannot be used at later stages. Of the other two, one is considered the easiest way to a safe harbor at all funding stages, and the last one enables company insiders to perform the valuation.

Join us as we discuss the importance of 409A valuations, different valuation methodologies, the stages where they are most suitable, and how frequently startups need valuations at different stages.

Importance of 409A valuations

A private company issuing stock-based compensation to its employees is required by the Internal Revenue Service (IRS) to do so based on a valuation compliant with Section 409A of the Internal Revenue Code (IRC). Such a valuation is simply referred to as a 409A valuation.

409A valuations take a different approach from fundraising valuations. Investors and founders will negotiate the fundraising valuation based on the startup’s current standing, past achievements, and growth potential. They may also look at the valuation of other similar startups.

On the other hand, 409A valuations are meant to establish a startup’s fair market value (FMV). A company’s FMV is a price someone will willingly pay after knowing all the material facts about it. So, any sort of bias or speculation has no place in 409A valuations. Since startup valuations are swayed by the growth potential of the startup and the negotiating power of each party, 409A valuations are usually not equal to fundraising valuations.

A closer look

It is a misconception that startups do not need to get 409A valuations or that 409A valuations are necessary only for issuing ESOPs. 409A valuations are needed for issuing all types of deferred stock-based compensation including phantom stocks, restricted stock units (RSUs), some performance-linked benefits, stock appreciation rights (SARs), and deferred stock units (DSUs).

Basically, if the compensation is linked to equity and there is a vesting period, you must get a 409A valuation.

If you issue stock-based compensation without 409A valuations and the IRS thinks that you issued said compensation at unreasonable valuations, any deferred compensation that you have so far allotted to employees will become immediately taxable.

The IRS can also levy a penalty tax on the unpaid taxes and charge a higher-than-normal interest on the unpaid taxes. These burdens will be borne by your employees. Such a situation can give rise to legal disputes between you and your employees.

Which 409A valuation methodologies help secure safe harbor status?

If you secure safe harbor status, you need not go out of your way to prove that your valuation for issuing stock-based compensation was fair. Instead, the IRS presumes that it was a fair valuation. If they suspect something, they must prove that the valuation was grossly unreasonable and not the other way around.

Under the provisions of Section 409A, you can secure the safe harbor status by using the following methodologies:

Illiquid startup presumption

This methodology can be used by an illiquid startup, i.e. a private company less than 10 years old that does not expect to go public in the next 180 days or be acquired in the next 90 days. This method involves a company insider establishing an initial value based on the available financial information, comparable company transactions, preceding equity transactions, and any other material information. Then, a discount is applied for the risks involved and the illiquidity of the equity.

The company insider performing such a valuation must be a qualified individual and they must record their valuation process and results in a written format.

Example

Suppose you need to value your startup called InnovateTech and since it does not have a significant revenue or assets, you take the market approach. So, you identify 3 similar companies that were bought or sold in recent times, adjust their valuations for any differences, and take the average.

Company name	Valuation	How is it different from InnovateTech?	Adjustment in valuation	Adjusted valuation
TechStart A	$10 million	Less technologically advanced than InnovateTech	#ERROR!	$10 million + 10% = $11 million
InnovateNext B	$8 million	No significant difference	No adjustment	$8 million
FutureTech C	$12 million	Better market presence	-15% adjustment for a larger market presence	$10.2 million
Average adjusted valuation				$9.73 million

Since your startup is not as liquid as the 3 startups mentioned here, you will need to apply an illiquidity discount that typically ranges from 20% to 30%. For our purposes, we will apply an illiquidity discount of 25%.

So, the valuation of InnovateTech = $9.73 million X (1 – 0.25)
= $9.73 million X 0.75
= $9.73 million X 0.75
=$7.3 million
So, the 409A valuation of InnovateTech can be set to $7.3 million.

Binding formula presumption

If your company’s equity is bought and sold in binding agreements based on one formula every single time, then you may use this formula to issue stock-based compensation. This method is a double-edged sword since it simplifies valuations for your company but also puts limitations on how your company can be valued for any kind of equity-related transaction.

Example

Suppose your company, HealthTech Solutions, always uses a revenue multiple of 3x to set the valuation whenever its equity is sold. Let us assume that your company had an annual revenue of $10 million. Then, the valuation for your company can be calculated as:

Annual revenue	$10 million
(X) Revenue multiple	(X) 3
409A valuation	$30 million

So, the 409A valuation for HealthTech Solutions will be $30 million.

Independent appraiser presumption

If a valuation is performed by a qualified and independent appraiser, it will be enough to secure safe harbor status for a certain period. Of all the methodologies, this happens to be the most cost-efficient and convenient one.

A valuation performed using any of the mentioned methodologies will secure safe harbor status for 12 months or until a material event occurs, whichever is earlier.

Example

Suppose your company TechStartup Inc engages Eqvista for 409A valuation. The process would have the following steps:

• Your company sends an engagement letter to Eqvista outlining the scope of work, fees, and timeline.
• We will request various documents like financial statements, capitalization tables, business plans, and any recent transaction documents. Based on the documents received, we will initiate an analysis of your industry, the market, and your company.
• Now, we will choose the appropriate approach for the 409A valuation of your company. We will choose from income, market, and asset-based approaches. We may also choose to take the weighted average of valuations from a combination approach.
• We will determine the amount of value to be allocated to each class of equity shares.
• We will prepare a detailed report containing an executive summary, company overview, description of the valuation methodology, financial analysis, and valuation conclusion.
• Now, you can review the report, and provide any feedback which we will incorporate and finalize the 409A valuation report.

409A valuation at different funding stages

Here, we will discuss the most appropriate valuation methodologies for each stage in a startup’s journey.

Pre-seed and seed stage

In the early stages, you may not have the leeway to hire finance specialists with the required valuation experience to use the illiquid startup methodology. So, you are left with the binding formula methodology or the independent appraiser methodology.

Typically, there will not be a lot of binding agreements at this stage except fundraising. So, you can use the binding formula methodology.

However, this can be a missed opportunity to offer equity to employees at a lower price than the fundraising price. If this does not limit your ability to attract talent, you should use the binding formula method.

Series A

Even at a Series A stage, most startups will not hire specialists for functions like finance and accounting. Specialists may be welcomed for product development and for developing a go-to-market (GTM) strategy. So, even at this stage, hiring a valuation expert solely for issuing stock-based compensation will be like putting the cart before the horse. However, if your finance head happens to be a valuation expert, using the illiquid startup method is a valid choice if it does not distract them from more critical tasks.

Once again, we are left with the binding formula method and independent appraisal method. Of the two, the independent appraisal method is the more convenient one. Since valuations really start to climb from Series A, using a binding formula may limit your ability to attract talent. After all, your prospective employees will prefer to maximize their gains by buying at low prices.

Series B, C and beyond

Once you can start inviting specialists to your team, you may also add a valuation expert to your team. Such a team member may also perform other finance and accounting-related functions besides 409A valuations. However, they will need to keep up with 409A regulations.

As your startup progresses up the ladder, liquidity events get closer and it will become harder to use the illiquid startup method as your startup will literally cease to be illiquid. If you have reached this stage, we would like to congratulate you on your progress and hope that there is more in store for you.

A Series B and beyond startup will find it difficult to use the binding formula simply because business dynamics change and setting valuations using the same formula since inception becomes impossible. So, from Series B onwards, independent appraiser valuations are the only logical choice for most startups.

Key points about 409A valuations across funding stages

• Frequency – Companies typically need to update their 409A valuation annually or when a material change may impact the business value.
• Valuation methods – The choice of valuation method may evolve as the company grows:
  • Early-stage companies often use the asset approach or market approach.
  • Later-stage companies may employ more complex methods like the income approach or option pricing model (OPM).
• Comparison to fundraising valuation – 409A valuations are generally lower than fundraising valuations because:
  • They focus on common stock, which has fewer rights than preferred shares sold to investors.
  • They consider the liquidation preferences and other rights of preferred shareholders.
• Factors considered – As companies progress through funding stages, additional factors come into play:
  • Early-stage – Focus on recent funding rounds, financial projections, and market potential.
  • Later-stage – Greater emphasis on unit economics, the path to profitability, and competitive landscape.
• Impact on stock options – The 409A valuation determines the strike price for employee stock options, which is crucial for attracting and retaining talent.
• Compliance – Accurate 409A valuations help companies avoid tax penalties and protect employees from potential tax issues.

How frequently do you need 409A valuations at different stages?

If you recall, private companies can secure a safe harbor status if they use the prescribed methodologies to get a 409A valuation every 12 months or after material events. So, the frequency of 409A valuations depends on how frequently material events occur for a startup.

Case study for understanding the frequency of 409A Valuation

Let us assume that you are the founder of a startup called Selma Solutions. Currently, Selma Solutions is at the pre-seed stage. Right now, you will be developing your product and researching your target audience’s preferences and needs. Selma Solutions will not focus on signing big contracts or generating revenue. So, material events may not occur at the pre-seed stage. Hence, a 409A valuation every 12 months will suffice.

When Selma Solutions secures seed funding, it will count as a material event. So, you will need a 409A valuation before you can issue stock-based compensation again. Even after securing seed funding, material events may be rare for Selma Solutions because its focus may still be on product development.

If Selma Solutions can produce a minimum viable product (MVP) and find the right market for it, it may secure Series A funding. This, too, is a material event. From this stage until going public or being acquired, Selma Solutions may experience a high growth period, i.e. there will be a myriad of material events like signing significant new contracts, improving financial performance, and major equity transactions. After every such material event, Selma Solutions will need a 409A valuation.

You can understand if you need a 409A valuation through the following decision tree.

Eqvista, 409A expert for startups of all stages!

Not getting a 409A valuation can have grave consequences for your employees. They may have to pay expensive taxes which are completely avoidable. All you need to do is simply use one of the three prescribed valuation methodologies to establish the purchasing price offered to employees in stock-based compensation.

If your startup is not expecting a liquidity event, you can also use the illiquid startup method. For using the binding formula method, you must commit to a single valuation formula for all equity transactions.

At all stages, getting an appraisal from an independent expert like Eqvista is the most convenient method. Contact us to know more!