409A Valuations: Understanding the Process & Managing Risk

Ever wonder when a startup issues stock options to its employees, how the value of these options come about? For most private companies, the main way they can grant options to their employees is through a 409A valuation.

This article will explain all you need to know about the 409A valuation process and managing its risks. So keep reading to know more.

Three common 409a Valuation Approaches

Based on a justifiable methodology, an independent valuator has a responsibility to ensure that the 409A valuation is fair and offers an accurate picture of the company. There are three main 409a valuation method types that they normally choose from, being the Market Approach, Income Approach and Asset Approach.

Market approach

The process where the value is determined for a business depending on a comparable situation and similar market forces is the market value approach to business valuation. The comparable situation in this context is a market quote of securities which are listed of a comparable public company, a transfer of ownership transaction that involves a comparable company (private or public), or a former transaction concerning the same business.

Typically valuation providers use an option-based valuation backsolve method when a company raises financing rounds. Investors receive preferred stock, even though it is assumed reliably that new investors have paid the fair market value for equity. So, for common stock prices to be determined, adjustments should be made.

To estimate the company’s equity value, some other market-based approaches utilize financial data like EBITDA, net income, and revenue from comparable public companies. In other words, the market approach evaluates an intangible asset or a business in relation to other genuine value transactions. The core backing the market approach is deriving the price that is a multiple of a benchmark, being the price to book value, EV to EBITDA, price to earnings ratio, etc.

To know more, check out our detailed article Business Valuation: The Market Value Approach.

Example for Market Approach:

Here is an example of how to compare different companies within the same industry.  Let’s take the company Zephyr AI and perform a comparable analysis.

Based on the financial ratio analysis for Zephyr AI, it has a good standing compared with the other comparable companies. Thus, the median EV/REV multiple was used at 2.37, times an expected revenue level of $500,000, resulting in a firm value of $1,185,000.

If we take the expected sales then Enterprise Value of Zephyr AI = 1,185,000

Income approach

Valuation providers usually use a straightforward income approach for businesses with positive cash flow and sufficient revenue. This 409a valuation method is estimated at the present value of future cash flows or future earnings.

By projecting the revenue of the business and adjusting it for the change in cost structures, growth rates, taxes, and others, the cash flow or future earnings are determined. The discount rate of return for an investor is reflected by using a discount rate which is determined by the present value. The income approach does not rely upon any previous similar transactions in the market, which makes it an effective and powerful 409a valuation method.

Nevertheless, these inputs have to be sound because the value adopted is highly sensitive to the required rate of return and estimated growth rate. There are various methods incorporated in this as well.

To know more, check out our detailed article Business Valuation: The Income Approach.

Example for Income Approach:

So, let us say that a company has a Net Cash Flow of $195,419 in the final year of the projection period.

Terminal value is calculated as shown below:

The terminal value is then discounted using a company’s Weighted Average Cost of Capital (21.15%) and added to the present value of the free cash flows.

So, in the above example, the value of the business is $1.56M.

Asset approach

The asset approach is for early startups that have not yet raised enough money to generate revenue or asset-reliant companies. To determine a precise valuation in this 409a valuation method, the valuator calculates the company’s net asset value. This method is the only 409a valuation method that stands out as it is mostly used when a company wants to exit or is about to be liquidated. It is because this 409A valuation method examines the total value of assets in the company.

The assets are of two types in a company: intangible assets such as trademarks and copyrights, and tangible items like cars and real estate. With the company books in hand, the market value of a few of these mostly tangible items can be determined. But in the case of intangible assets, it becomes extremely complicated to calculate the value.

To know more, check out our detailed article Business Valuation: The Asset-Based Approach.

Example for Asset Approach:

Let us get a better understanding of the asset-based valuation method by looking at an example. 

Green Tech Innovations is a company focused on developing cutting-edge technology software products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience.  

To understand things better, below is the unadjusted balance sheet of the company along with the adjustments made. 

At this point, can get the shareholder’s equity value for the adjusted balance sheet.

409a Valuation Process

The time taken to complete a 409A valuation ranges drastically from days to months. It mostly depends on the requirements of the client and the situation. It is essential to understand the entire process and time needed for every step.

The following steps will help you understand how the frame looks like when you deal with a valuation firm:

Step 1 – Determine the needs of the company – (Handing over data)

We start by determining if the 409A valuation is the right thing for the organization before commencing the valuation process. Also, we are required to ascertain the relevant valuation date. In certain cases, for the company to get a better valuation, they have to wait a couple of months. This helps them get better value for their money.

If the organization identifies the need for a 409A valuation, we go ahead and conclude the date of valuation needed for the report. In different cases, several people have to be engaged with the company like legal counsel, board, management, investors, and others.

During the engagement, some back and forth might take days to weeks to conclude whether they want to go ahead with the appraisal and choose a suitable date for a valuation.

Step 2 – Sign the engagement letter and collect payment

It usually takes approximately a day to a week for this to happen. Once the terms are agreed upon, we will send over the engagement letter to sign. Also, instant payment through Stripe is accepted to wire the payment.

Step 3 – Upload company documents

Clients are able to securely fill their information and upload the essential documents through the Eqvista App. But, in some cases where companies are required to draft their financial projections for five years, it takes time. Companies also take time to assemble the financial statements year to date in cases where the valuation date freshly passed. So depending on the situation, clients might finish it in an hour or several weeks.

Step 4 – Complete draft 409A valuation report

The draft valuation report takes about two – three weeks to complete. Sometimes more data or documents are required, and this takes some additional time. In cases where the company needs a fast turnaround, it may be done faster, but it has additional charges. While it is not normal to do so, it is still possible.

Step 5 – Draft review

The clients are provided with the chance to examine the draft report before they get the final certified report. Then meetings for the discussion about the inputs and assumptions for the valuation to make sure we defined the company accurately. If any changes need to be done, this adds a few days to complete depending on the scenario.

Step 6 – Final certified 409a valuation report

A representation letter is requested from the company once the draft valuation is agreed upon with the company’s management. After receiving the signed letter, the final valuation is delivered.

Managing Risk: Safe Harbor for 409a Valuations

When a 409A valuation is conducted by a third party appraisal, it becomes eligible for a safe harbor status. It is basically a valuation where unless proven by the ISR to be “grossly unreasonable”, the determined value stays valid. So, if a company gets a third-party that follows the rules of the 409A as per the IRC and gets the company’s valuation done, it would be given safe harbor protection. This would help you avoid any penalties that might come later.

In fact, here is what can happen to the employees who get incorrectly priced options:

• The option-holders would be taxed on the options they hold immediately.
• They will be fined an additional 20% of the value of their option grants and might have to pay other penalties as well.
• The company would have to spend lots of money on potential lawsuits or other legal matters, if the IRS makes a case.

So, the best way to avoid all this is by getting a 409A valuation done by a professional third-party firm and following all the rules of the IRS.

With that said, all 409A are required to follow a reasonable valuation method and exercise a reasonable application. Even though other methods of valuation could pass IRS standards, the two main approved safe harbor methods companies could use to adhere to IRS standards are:

Independent Valuation

The safest and most common way to get a valuation and have safe harbor protection while complying with the IRS is to hire an independent company with the knowledge and experience to do it. They should be granted complete access for assessment and consider all the data material that helps assist in determining the valuation of the company’s common stock.

In a 409A valuation, it is assumed reasonable if no material change occurred within the valuation and grant date, and the stock was valued within 12 months of the grant date. If all these requirements are adhered to and met, then it is on the IRS to prove your valuation “grossly unreasonable”.

Illiquid Startup Inside Valuation

An inside valuation is also 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 safe harbor 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:

• 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.
• It should have been in business for no more than ten years

The person who does this valuation has to be considered as a qualified person. And even though the IRS does not have determined rules for the qualification, they did share some established clarification. It is that the person has to have at least 5 years of experience in the relevant areas such as secured lending, financial accounting, private equity, business valuation, investment banking and other comparable experiences.

409a Valuation Example

Now let us take an example to understand 409a valuations better.

Let’s say an early-stage company has just raised a round of about $10 million with a $40 million valuation.

But since the company has only a few customers, and the product doesn’t yet have a lot of traction, the 409A framework is what helps out.

• The company decided to take on its initial investment in the form of funding, from investors. The total amount of the funding was $10 million to support the company to develop its product and expand its market. 
• The company’s value increases to $40 million after funding.
• A 409A valuation for the company, as their funding round sets the pre-money valuation of the company for investors to invest, this also sets the share price for the shares.

Method of Valuation

• For a company that doesn’t have a proper path to an exit, an option-pricing model is used mostly to distribute value. The funding round is worked backward to arrive at a value for both the common stock and the startup. 
• This is different from the traditional 409A valuation methods, in which a top-down approach – determines the business value of the startup and then uses an option-pricing model to distribute the value.
• If the company is away from a round of financing, valuation starts to offer more weight to the market movement and financial projections.

Get your company 409a Valuation from Eqvista

At the end of the day, you need to ensure that you select a valuation firm that can give you the desired results using the right 409A valuation method. Additionally, it’s also important to ensure that the firm is one that you can have a good relationship with since it is vital for every company to get its valuation done every year or before a new issuance. With this in mind, Eqvista is here to help.

Eqvista now offers professional 409a valuations for companies with our independent business valuation services. With the help of Eqvista’s valuation services, our client’s can easily manage both their seed-stage to IPO stage valuation and equity in a single scalable solution. So, if you are ready to have your 409A valuation done with the right 409A valuation method, schedule a call with us today!