409A Valuations – Startups

A proper 409a valuation would show the value of the company, and ultimately the stock options given to employees.

When a startup is created and is in the idea phase, it has little worth and may lack proper funding until the operations get off the ground. Due to this, the company may not be able to afford high salaries for talented new hires. In this case, you need a way to pay your staff, and one way is by offering them company stock options. And for this, you will need to look into 409a valuations for startups.

A proper 409a valuation would show the value of the company, and ultimately the stock options given to employees. Without this, the company would be unable to determine how much each option is worth, and how much tax is to be paid on these later when they are exercised, or when the shares are sold.

This article will help you understand all you need to know about 409A valuations in startups.

409a Valuation for Startup

The Internal Revenue Code (IRC) Section 409A was created solely to regulate the way companies treat so-called “nonqualified deferred compensation”, which is given out to employees in place of a high salary. A 409A valuation is normally performed to assist companies to set up a current strike price for the employee stock options that are about to be issued to employees. These options have to meet the IRS requirements of having a proper Fair Market Value (FMV).

Why Startup Founders Need to Know about 409A valuations?

The best way to get this done is by having an objective and qualified third-party perform the 409A valuation for startups and other big companies. This means that the companies will have to hire an appraisal firm, which is not as daunting as it sounds. Just so you know, the is there so that the federal income taxes are paid on deferred compensation plans. It also helps companies make sure their options value is covered by the IRS safe harbor protection.

This means that companies that do not comply may face fines down the road for non-compliance, resulting in a 20% tax and interest payments. Also future investors may be weary of funding a company with multiple tax risks and indemnities due to failures to follow tax rules. And this is why, regardless of if your company is just a startup offering stock options, it is highly crucial for you to have the 409A valuation for startups performed by professional.

When does my startup need a 409a Valuation?

With that said, there are a few reasons to have a 409a valuation performed. They are:

  • When you are about to offer stock options to your employees you need the 409A valuation to get the strike price of the options.
  • Every 12 months (A 409a valuation is only valid for 12 months from the valuation date)

Let us explain this a bit more and take an example. Let’s say there is a company that wants to hire top-notch talent with experienced professionals with a background in the industry. But the company does not have the money required to pay them competitive salaries. In this case, they decide to offer the employees with stock options, which is nonqualified deferred compensation as referred to in Section 409A.

And as per the rule, if a company wants to offer options to their employees, it is important to get a 409A valuation performed. A proper 409A valuation performed by a professional appraiser will help you ensure that your option plans are covered by safe harbor protection. There are a lot of companies that tend to put their company’s valuation until after the Series A funding as some firms can charge up to $5,000 for a 409A valuation!

And if you are worried about the cost, check out the starting price at Eqvista. Eqvista is both professional and offers reasonable rates. It is better to spend the amount now than to pay higher overheads for possible penalties by the IRS later.

Exceptions of Illiquid Startup for 409A valuations

The very first choice for getting your 409A valuation is one done internally by a qualified individual. An inside valuation is acceptable for those small startups that have not yet grown to a point where they can bear expensive independent valuations. The illiquid startup insider valuation method permits you to do so, but there are rules that need to be followed before being eligible to be qualified for this method. They are:

  • The company should be less than 10 years old.
  • No common stock subject to put or similar obligations or call rights
  • The company should not have any publicly traded securities
  • The company should have no reasonable expectation of going public within the next 180 days; and/or being acquired in the next 90 days.

In addition to this, the individual performing the valuation has to be considered “qualified”, which usually means having at least 5 years of experience in relevant areas like private equity, investment banking, financial accounting, business valuation, secured lending or other comparable experiences. Due to this, the valuation is normally done by the CFO or board member.

But as the IRS does not have clearly defined terms for work experience in the field, it may lead to confusion on whether or not you fit all the requirements. As many companies wish not to risk any possible negative tax effects, most opt for third party evaluators to provide a 409a valuation for their startup.

409a Valuation and Venture Capital Valuation

A 409A valuation is performed by compliance experts and is the estimate at the low-end of a defensible valuation range, while a VC valuation is the market value negotiated between entrepreneurs and the VC offering the company investment in exchange for equity. In fact, a 409A valuation and a VC valuation can be performed at the same time, and both will have different final values.

VCs do not take the 409A valuations into consideration as an input for their valuations. But the experts who perform the 409A valuations always take the VC valuations, if any, into consideration.

To explain better, professional valuators recognize the value of an asset in the company at its FMV. And the IRS considers the FMV of something like the price at which the property would be sold in the open market. So, the 409A valuation is usually the price that the buyer and the seller have agreed on, with neither of them required to act and both have a reasonable understanding of all the facts and details that lead to the value.

In short, both the valuation methods have their own uses. The 409A valuation is performed for the company to issue shares to its employees and follows the rules of IRC Section 409A. On the other head, VC valuations are done by VCs to invest in the company and determined based on the pre-money valuation.

So, if you see a difference in your VC valuation and your 409A valuation, you now know why this is. To know more about the difference in both the valuation processes, check out our article here!

409A VALUATION FOR PRE-REVENUE STARTUPS

Pre-revenue startups are also those that are at the early stage of building their business and making sales. Pre-revenue startups are valued like seed rounds. Investors invest money for equity. To calculate their percentage of stock, they must value the company, which is always challenging.

Pre-revenue valuation is likely to be heavily reliant on estimates. Suppose you determine the value yourself without consulting an independent appraiser or a financial expert. In that case, you will have the burden of proving that your assessment was reasonable at the time if the IRS challenges you later.

409A VALUATION FOR PRE-SEED FUNDED STARTUP

To raise pre-seed funding for your startup, you need a good product, an attractive business model, a credible team, and a network. If you are raising pre-seed financing, including a 409A valuation as a part of the pitch deck is essential. Furthermore, to issue equity grants for hiring top talents, the FMV of the startup’s stock might be used to determine the equity compensation’s value.

Secondary trading can affect the valuation of pre-seed funded startups and discourage potential investors. However, proper strategies can minimize associated risks.Understand more about 409A valuation for pre-seed here.

409A VALUATION FOR SEED FUNDED STARTUPS

A startup at the seed stage usually requires a 409A valuation to assess its worth accurately and make informed decisions regarding funding. Potential investors will likely demand a 409A valuation if you plan to raise seed capital. 

Additionally, other financial transactions may necessitate a 409A valuation. However, it’s important to note that a startup isn’t obligated to obtain a 409A valuation before accepting investor investments.Read to know more about the 409A valuation for seed fund startups.

409A VALUATION FOR SERIES A FUNDED STARTUPS

Investors consider the 409A valuation a vital step in Series A funding. It determines the fair market value of privately held organizations’ common stock per the Internal Revenue Code (IRC). 

If you’re considering raising a Series A funding round, providing potential investors with a comprehensive business valuation report and a 409A is crucial. Your valuation should be based on the most recent transaction with similar characteristics and features, and it’s important to keep it realistic. Read to learn more about 409A Valuation for series A funded startups.

409A VALUATIONS FOR SERIES B

409A valuation for Series B-funded startups is an advantageous tool that may help you secure Series B funding for your startup. A 409A valuation report is significant in obtaining Series B funding.

It provides investors with essential information to make informed investment decisions and ensures fair and reasonable compensation for stock-based compensation. Its necessity depends on your needs and goals, but it can be an attractive option if you’re seeking Series B funding. Understand more about 409A valuations for series B here.

409A VALUATION FOR SERIES C FUNDED STARTUPS

A 409A valuation is crucial when raising Series C funding, especially if you’re pitching to venture capitalists. It supports the facts presented in the pitch deck and provides a fair idea of the company’s value. 

The purpose of 409A valuation in Series C funding is to establish a fair market value for a startup’s common stock. This creates a benchmark for investors to determine what they are investing in. Do your research and plan accordingly, considering other factors like financial projections and company valuation.Learn more about 409A Valuations for series C funded startups here.

What are the Possible ways to get 409a Valuation

There are three ways by which you can get a 409A valuation of your startup performed. Just note that out of the three ways, only one method offers the safe harbor status keeping your company away from an IRS audit. But just to let you know the methods, we have shared them below:

#1 Do it yourself (DIY)

You can get your valuation done by yourself, especially if you know a lot about it. But this is the riskiest method you can opt for. Should the IRS get involved, you will have to prove that the valuation you gave is right. And it is rarely a case where it turns out right in such a situation. So, this may lead to you having to deal with the penalties that come your way. With this said, ask yourself, is it worth the risk?

#2 Use any valuation software

The next 409A valuation method is by using a software application to get the valuation. Yes, there are many software applications out there but are they reliable? Every company has its own kind of assets. And when the 409A valuation providers value a company, they never use a specific method. Each company has a different case and based on the case, a method or multiple methods are combined and used.

#3 Hire a valuation provider

The last option is to go through a 409A valuation provider. But it is much better to pay for a 409A valuation method that is less risky and gets safe harbor protection. With this, the IRS would normally trust your valuation and you could avoid any tax penalties later on. Additionally, you will not have the burden of proving the IRS that your valuation is right.

Choosing 409a Valuation Providers

When selecting a provider for 409A valuations, it’s important to consider your options carefully. What makes Eqvista an excellent choice is that it’s cost-effective and efficient and never compromises quality.

  • Experience: Working with a valuation advisor who has the relevant experience can help companies shape their point of view and save them a lot of potential pain down the road.
  • Support: In fact, for private companies, a 409A valuation is very important and it is critical to have the right level of support for any conclusion of value.
  • Audit Review: Companies can benefit from audit review support during audits, financial statement reviews, or SEC examinations. This support can help alleviate pressure on the founder or CFO to address potential legal or compliance issues quickly.
  • Scalability: As the company grows and considers going public, it’s important to consider if the valuation provider can keep up with the scaling demands.

Frequently Asked Questions from startups

For most startups, they might not know the importance of a 409A valuation for their firm. To help you understand better, we have answered the most asked questions from startups about 409A valuations.

Why is a 409A valuation important for startups?

The primary reason why its essential for startups is the fact that it helps them to set the strike price for the stock options based on the 409A valuation, which ultimately provides fair and accurate pricing in line with their valuation. In fact, as per IRS it is required to conduct a 409A valuation every year.

Does 409A valuation apply only to US startups?

Probably if a startup with a subsidiary in the US or a non-US startup with US citizens as their employees are required to carry out a 409A valuation. The reason for this is the fact that the rules and regulations that govern the issuance of equity options apply to the US only.

When should I update my 409A?

You are required to conduct a 409A valuation every 12 months. Moreover, you can consider an updated 409A valuation report when you are planning to raise a new round of funding, in the event of debt financing, or in case of any situation that changes the valuation of the company.

How accurate are 409a valuations?

409A valuations are generally considered as an estimate of the fair market value of the equity. As per the IRS, it is essential for us to consider a wide range of factors that can affect the valuation of the company in order to ensure that we provide a reasonable estimate of the fair market value.

How Much Does A 409A Valuation Cost?

The cost of a business valuation can vary depending on its purpose, type of engagement, and complexity of the appraisal. IRS tax code mandates that 409A valuations cost between $2,000 to $5,000+ based on complexity and provider.

Eqvista’s 409a valuation pricing tiers are based on funding rounds, but may vary depending on other factors including: total revenue, number of employees and capital structure. e.g. A closely held company with sales of $5 million, 50 staff, and no previous funding, may be equivalent to a Series B company. Tell our staff more information for an accurate quotation.

How Long Does a 409A Valuation Take?

A 409a valuation process typically takes two weeks and one month to complete. However, valuation providers like Eqvista will complete the 409a valuation within 3-5 working days. Also, Eqvista’s 409 A Valuation is unlimited for clients upto 12 months.

Eqvista – Your trusted 409a Valuation provider

409A valuation for startups is still something new for some entrepreneurs. And we do not blame them, which is why articles and knowledge centers exist on our website to help you understand everything better.

But remember that no matter what, you should always choose the firm that you can trust and see building a good relationship with since you will be needing their services almost every year. With that said, Eqvista provides professional 409a valuation services for both startups and larger companies. So, if you want your valuation handled by us, contact us today. Our 409a valuations start at $990 and are set based on your company details.

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