409A Valuation Methodology And Process: Case Study
In this case study, we are giving a peek under the hood of 409A valuations.
Have you ever wondered how a 409A valuation is different from a fundraising valuation? Sure, it helps compensate employees with stocks but has no role in fundraising activities. Some may even know that it relies purely on cold hard data and has no room for bias. However, none of this may satisfy you, if you want to understand the difference in methodologies.
In this case study, we are giving a peek under the hood of 409A valuations. We will go over every step in 409A valuations right from understanding the company and its industry to applying the appropriate methodologies and estimating the valuation. Hopefully, this 409A valuation example will give some much-needed perspective to those who are curious.
What is the goal of the 409A valuation case study?
Tech Corp is a fast-rising cloud storage startup known for its AI-powered data security solutions. It wants to issue stock options but before it does so, the Internal Revenue Service (IRS) requires it to get a 409A valuation.
Stock options are a type of nonqualified deferred compensation that is taxed as per Section 409A of the Internal Revenue Code (IRC). A valuation that complies with this section is referred to as a 409A valuation.
In this case, we applied the 409A valuation methodology to get the following results.
| Before 409A Valuation | After 409A Valuation | ||
|---|---|---|---|
| Price Per Share (Board Determined) | $0.0001 | Fair Market Value (FMV) (409A Valuation) | $0.0742 |
Before beginning the 409A valuation process, it’s important to have a thorough understanding of the company.
Company information
Tech Corp is a sophisticated software company launched in June 2023, offering cloud storage and AI-powered data security solutions. It excels in delivering AI-powered products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience.
One of Tech Corp’s products is its cloud-based storage tools, revolutionizing how businesses collaborate and communicate in today’s interconnected world. These tools provide everything from document management and project collaboration to communication and data analysis, helping organizations streamline their workflows and achieve optimal performance.
Furthermore, Tech Corp is invested in emerging technologies such as artificial intelligence, machine learning, and the Internet of Things (IoT), to develop solutions that drive innovation across industries.
Overall, Tech Corp is an example of innovation and excellence in the tech industry, continually pushing boundaries and redefining the digital landscape. With dedication, quality, creativity, and customer satisfaction, Tech Corp remains a trusted partner for businesses and consumers.
Product of the Company
Tech Corp’s product is its cloud-based storage tools, revolutionizing the way businesses collaborate and communicate in today’s interconnected world.
Cap table
The founders of the company are Peter Anderson and Jessica Stewart. Their diverse expertise in engineering, business, and design is expected to drive the company’s growth in the industry.
The founders own 410,000 shares each, accounting for 820,000 shares in total.
Take a look at the company’s cap table:
| Equity | Shares | Capital | % Fully Diluted |
|---|---|---|---|
| Common | 820,000 | $ - | 100.00% |
| Total Fully Diluted Shares | 820,000 | $ - | 100.00% |
Financial statements
Let’s analyze the company’s financial position by reviewing the Income Statement and Balance Sheet.
Income statement
The Income Statement summarizes the company’s revenues, and expenses for a specific period as shown below.
The statement covers the last 6 months of 2023 and the first quarter of 2024 since the company was launched in June 2023.
| Income Statement For the Year Ended December 31st ($) | March/2024 | 2023 |
|---|---|---|
| Revenue | ||
| Sales Revenue | 75,000 | - |
| Interest Income | 25,000 | - |
| Total Revenue | 100,000 | - |
| Gross Profit | 100,000 | - |
| Operating Expenses | ||
| Salaries and Wages | 20,000 | 10,000 |
| Rent and Utilities | 10,000 | 10,000 |
| Marketing and Advertising | 7,000 | 5,000 |
| R&D | 9,000 | 4,000 |
| Insurance | 10,000 | 10,000 |
| Other Operating Expenses | 6,000 | 6,000 |
| Total Operating Expenses | 62,000 | 45,000 |
| Net Operating Income | 38,000 | (45,000) |
| Other Income/ Expenses | ||
| Other Income | 20,000 | 10,000 |
| Other Expenses | 30,000 | 30,000 |
| Net Other Income | (10,000) | (20,000) |
| Net Income | 28,000 | (65,000) |
Balance sheet
The balance sheet provides the company’s financial position listing the assets, liabilities, and shareholders’ equity.
The company took on long-term debt in 2024, expecting significant growth in the upcoming months.
| Balance Sheets For the Year Ended December 31st ($) | March-2024 | 2023 |
|---|---|---|
| Assets | ||
| Current Assets | ||
| Cash and Cash Equivalents | 472,919 | 363,465 |
| Accounts Receivable | 11,000 | 9,000 |
| Total Current Assets | 483,919 | 372,465 |
| Non-Current Assets | ||
| Startup and Organizational Costs | 2,586 | 2,586 |
| Total Non-Current Assets | 2,586 | 2,586 |
| Total Assets | 486,506 | 375,052 |
| Liabilities | ||
| Current Liabilities | ||
| Accounts Payable | 5,457 | 4,852 |
| Short-term Loans | 5,000 | 5,000 |
| Accrued Expenses | 20,000 | 20,000 |
| Total Current Liabilities | 30,457 | 29,852 |
| Long-Term Liabilities | ||
| Long-term Debt | 12,700 | - |
| Deferred Tax Liability | 7,000 | 7,000 |
| Total Long-Term Liabilities | 19,700 | 7,000 |
| Total Liabilities | 50,157 | 36,852 |
| Shareholders' Equity | ||
| Opening Balance Equity | 3,200 | 3,200 |
| Retained Earnings | 5,149 | - |
| Shareholders' equity | 400,000 | 400,000 |
| Net Income | 28,000 | (65,000) |
| Total Shareholders' Equity | 436,349 | 338,200 |
| Total Liabilities and Shareholders' Equity | 486,506 | 375,052 |
409A valuation process
409A valuation analyzes and estimates the fair market value (FMV) of a company’s common stock.
The valuation is necessary for compliance with Section 409A of the IRC, which regulates the taxation of non-qualified deferred compensation. Additionally, it enables employees to file an 83(B) election, minimizing tax liabilities and optimizing tax treatment on future gains.
Section 409A requires private companies to obtain a 409A valuation to determine their common stock’s fair market value (FMV) before granting stock options or other equity-based compensation.
Which is the best 409A valuation methodology?
There is no best 409A valuation methodology in general. Each method has its merits and demerits. You must choose the one best suited for the company you are valuing. We can group most 409A valuation methods under three main approaches which are the market approach, the income approach, and the asset-based approach.
Market Approach
This approach is fundamental to valuation as the fair market value is determined by the market. The valuation is done by comparing the company with other similar companies in the market. The method can work if there are a good number of similar companies to be compared to.
Income Approach
This method of valuation is based on the idea that the value of a business lies in the ability to generate revenue in the future. The most common method of valuation under the income approach is capitalizing past earnings.
Capitalization of earnings calculates the net present value of the expected future cash flows or future earnings of the company and divides them by the capitalization rate.
Asset-Based Approach
This method includes the addition of all the assets of the business. It focuses on the fair market value (FMV), or the company’s net asset value. Calculating the total assets less the total liabilities to evaluate the cost of the company.
Calculating the 409A valuation
For a company like Tech Corp in the early revenue stage, the asset-based approach in the form of the adjusted book value method is applied in the valuation.
To understand things better, below is the unadjusted balance sheet of the company along with the adjustments made.
| Balance Sheet As at 15th March 2024 ($) | Original | Adjustment | Adjusted |
|---|---|---|---|
| ASSETS | |||
| Current Assets | |||
| Cash and Cash Equivalents | 472,919 | - | 472,919 |
| Accounts Receivable | 11,000 | - | 11,000 |
| Total Current Assets | 483,919 | - | 483,919 |
| Non-Current Assets | |||
| Startup and Organizational Costs | 2,586 | - | 2,586 |
| Intangible Asset | - | 15,904 | 15,904 |
| Total Non-current Asset | 2,586 | 15,904 | 18,491 |
| TOTAL ASSETS | 486,506 | 15,904 | 502,410 |
| LIABILITIES & EQUITY | |||
| Current Liabilities | |||
| Accounts Payable | 5,457 | - | 5,457 |
| Short-term Loans | 5,000 | - | 5,000 |
| Accrued Expenses | 20,000 | - | 20,000 |
| Total Current Liabilities | 30,457 | - | 30,457 |
| Long-term Liabilities | |||
| Long-term Debt | 12,700 | - | 12,700 |
| Deferred Tax Liability | 7,000 | - | 7,000 |
| Long-term liabilities | 19,700 | - | 19,700 |
| Total Liabilities | 50,157 | - | 50,157 |
| Stockholders' Equity | |||
| Opening Balance Equity | 3,200 | - | 3,200 |
| Retained Earnings | 5,149 | - | 5,149 |
| Shareholders' equity | 400,000 | - | 400,000 |
| Net Income | 28,000 | - | 28,000 |
| Revaluation of Intangible Asset | - | 15,904 | 15,904 |
| Total stockholders' equity | 436,349 | 15,904 | 452,253 |
| TOTAL LIABILITIES & EQUITY | 486,506 | 15,904 | 502,410 |
At this point, we can get the shareholder’s equity value for the adjusted balance sheet.
| Before Valuation ($) | After Valuation ($) | |
|---|---|---|
| Total Assets | 486,506 | 502,410 |
| Total Liabilities | 50,157 | 50,157 |
| Revaluation of Intangible Asset | - | 15,904 |
| Total Stockholders' Equity (Total Assets – Total Liabilities) | 436,349 | 452,253 |
Thus, from a balance sheet perspective, the total value of Tech Corp, according to the asset-based approach, is worth $452,253 after adjustments.
Waterfall analysis and Black-Scholes Model
Before performing the Waterfall analysis and Black-Scholes Model, the company’s Cap Table and ownership percentage are shown below:
| Equity | Shares | Capital | % Fully Diluted |
|---|---|---|---|
| Common | 820,000 | $ - | 100.00% |
| Total Fully Diluted Shares | 820,000 | $ - | 100.00% |
- Apply the Black-Scholes Model to determine the claims on the equity value and the resulting “Breakpoints” or transition points. Each breakpoint represents a separate call option on the equity value of the company, and a relative allocation of the overall equity is derived for each of these call options.
| Breakpoint | Transition Value | Equity Class receiving Value | Description of Event |
|---|---|---|---|
| #1 | $ - | SAFE Notes | Liquidation Preference: SAFE Notes |
| #2 | $820,000 | Common Stock | Participation: Common Stock |
- Each “Tranche” identified represents a separate call option with a claim on the company’s equity value.
| Call Option Tranche | Strike Price | Black Scholes Model | Option Value | Transition Band Value | |||
|---|---|---|---|---|---|---|---|
| d1 | N(d1) | d2 | N(d2) | ||||
| TR 1 | $ - | 25.441 | 1 | 24.733 | 1 | 452,253 | 391,375 |
| TR 2 | $820,000 | -0.29 | 0.385 | -1 | 0.159 | 60,878 | 60,878 |
Estimation of value
With the calculations of the band value:
- Split each band into the equity share classes and allocate the total amount based on band value.
- The total value calculated over the total shares of each class yielded the price per share.
| Call Option Tranche | Tranche Band Value | Common Stock |
|---|---|---|
| TR 1 | 391,375 | - |
| TR 2 | 60,878 | 100.00% |
| Total Value | 60,878 | |
| Shares | 820,000 | |
| FMV of shares | $0.0742 |
From the waterfall analysis above, the common stock of the company is worth $0.0742 per share.
From this example, the company would need to set the FMV of the common stock at $0.07 per share to be used for issuing and exercising stock options.
FAQs on 409A Valuation Methodology and Process
Navigating the complexities of 409A valuation can be challenging for many businesses. To help clarify the methodology and process, we have compiled a list of frequently asked questions related to this.
Is a 409A valuation mandatory?
Yes, 409A valuations are mandatory for private companies issuing deferred stock-based compensation like restricted stock units (RSUs) and employee stock ownership plans (ESOPs).
What are 409A valuations used for?
409A valuations are used to determine the fair market value (FMV) of a private company in a manner that is compliant with Section 409A of the IRC.
Is the 409A valuation public?
No. A company’s 409A valuation is shared only with the Internal Revenue Service (IRS) and no one else. The valuation professional you hire will know your 409A valuation but they are required to keep such information private.
Unlock your startup’s true value with Eqvista!
In this case study, we performed the 409A valuation of Tech Corp, a cloud storage startup. Before diving into the numbers, we first understood what kind of company Tech Corp is and took note of its journey so far. Then, we looked at its financial information. At this point, we were ready to choose the valuation methodology. Here, we went with the adjusted book value method which comes under the asset-based approach.
Once we had the total shareholder’s equity, we applied waterfall analysis and the Black-Scholes Model and then finally estimated the FMV to be $0.07 per share.
The quality of a 409A valuation depends on your understanding of accounting and valuation principles, the company’s industry, and your ability to conduct market research. The 409A valuation in this case study was performed by one of Eqvista’s experienced and NACVA-certified valuation analysts. If you are compensating your employees with equity as a private company, get a 409A valuation from Eqvista.
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