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.
This article will help you understand all you need to know about 409A valuations in startups.
409a Valuation for Startups
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).
The best way to get a 409A valuation 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 409A valuation 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 409A valuation providers.
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!
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.
409a Valuation and Venture Capital Valuation
A 409A valuation for startups is very different from Venture Capital Valuations (VC 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.
When talking about the VC valuations, it is never considered as at FMV as the VCs try to value the stock at a rate that suits them best and is beneficial to them. Yes, the owner does have a discussion with the VCs about the price, but since they are the ones taking in the investment, the power usually lies more in the hands of the VCs. That is also why VC valuations are usually higher than 409a valuations, as the valuation professionals find the value towards the lower end of the acceptable range, and VCs don’t.
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!
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.
Now that is something that the software would not know. So if you choose to use valuation software for your company, know the limitations involved and how it may affect your overall share price.
#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.
But for this process, you need to find a knowledgeable and highly experienced firm that can give you the right and best service. The firm that has the right education and experience would be the best choice as compared to the other 409A valuation providers in the market.
Finding a 409a Valuation Provider
As mentioned above, you will want to get the 409a valuation provider that has the experience in valuing companies. 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. 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.
Frequently Asked Questions from startups
For most startups, they might not know the importance of a 409A valuation for their firm. Many new business owners are not aware of the significance of a 409A valuation. 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 409A valuation is 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.
Additionally, when a company is planning for an IPO, it often looks towards a 409A valuation, as it is an effective way of determining the fair market value of the equity at an early stage. Hence, for the successful growth of the business and for a sound future, it is important to understand the relevance of the 409A valuation.
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. As a result, if any of the above mentioned conditions are met, then the company is required to follow 409A valuation procedures.
When should I update my 409A?
One of the most common questions that many startups have is, “When is the right time to come back with an updated 409A valuation report?” Well, as per the rules and regulations, 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. However, we are required to maintain a certain degree of accuracy in the report. As per 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.
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 $1,100 and are set based on your company details.
Eqvista also offers many other services other than this. Eqvista is an advanced cap table application that helps you track and manage all the shares in your company. And the best part about Eqvista is that it is FREE to use (for small companies).
Here are some of the features of Eqvista:
- Share Management on the cloud
- Less time spent on data entry
- Company incorporation (Yes, we also help you in incorporating your company in the US)
- Issuance of electronic stock in seconds
- Manage your shareholders in one place & give them access to the cap table
- Share the cap table easily with lawyers, accountants and company consultants
- Scenario modeling to help you make a proper decision when you are about to exit or raise new funding rounds
- Get defensible 409A valuations
Eqvista provides professional 409A valuation services that start at $990 and the price increases based on the stage that your company is in.
So the best way to take care of everything from the shares in your company to 409A valuations is through Eqvista.