How to Align Your 409A Valuation with Market Trends

If you are a private company issuing stock-based compensation, you need to understand all the intricacies of 409A valuation to be tax-compliant, which will help you avoid millions of dollars in penalties and lawsuits. According to the Internal Revenue Code, the purchase price for such compensation has to be established using a 409A valuation.

A 409A valuation involves arriving at a price that would be accepted by the market if it had complete knowledge and understanding of all material facts about your company.

So, naturally, market conditions do affect 409A valuations. Economic downturns, sector-specific cycles, and market-wide conditions all affect investor sentiments and risk appetites. They also affect the availability of funds.

A Closer look into the 409A valuation Trends

In the Great Recession, especially in 2008, various banks and financial institutions like Lehman Brothers and Washington Mutual Bank failed. The effects of this crisis were felt in all sectors causing a fall in investor confidence in stock markets.

COVID-19 can be seen as a market-wide condition as it directly affected almost all sectors. In this period, investors fled to safe-haven assets like gold and bonds.

More recently, in 2023, the private equity sector saw declining deal volume and falling valuation multiples because of factors like a mini-banking crisis.This makes adjusting 409A valuations to market fluctuations a necessary task for startup founders.

Below, we will discuss some major factors that have the potential to influence 409A valuations: economic conditions, equity market conditions, and industry- or sector-specific changes.

What is the effect of market conditions on 409A valuations?

Market conditions consist of macroeconomic conditions, equity market conditions, and sector-specific conditions. In later sections, we will discuss how each set of changes impacts the analysis.

Macroeconomic Conditions and 409A Valuations

Macroeconomic conditions depict the state of the economy through factors like Gross Domestic Product (GDP), inflation, GDP growth rate, interest rates, government expenditure, and unemployment rate.

To simplify things, we will first understand the effect of rising GDP on startup valuations. Then, we will understand how other variables affect the GDP and in turn, startup valuations.

The GDP is the sum value of a country or region’s entire output in a year. If the GDP is increasing, then people must be demanding more goods and services than they did before. When the GDP is falling, then people must be demanding less goods and services than they were before.

So, we will assume that a rising GDP should be good news for most businesses and vice versa. If this was indeed the case, valuation for startups should go up with a rising GDP, and fall with a fall in GDP.

Now, let us see how other economic variables affect GDP:

Variable	Meaning	Effect on GDP
Inflation	The rate at which the general level of prices of goods and services is increasing and eroding the purchasing power of money.	Long-term high inflation reduces the purchasing power and can discourage consumer and business spending, which slows GDP growth. Moderate inflation shows that demand is slightly higher than supply and encourages production, thus leading to GDP growth.
Interest Rates	It is the cost of borrowing money and the reward for placing money in bank deposits.	Higher interest rates make it difficult to borrow funds and make people save more, reducing GDP growth. Lower interest rates could increase borrowing and spending, which could fuel GDP growth.
Unemployment Rate	It is the percentage of the labor force that is unemployed and actively looking for employment.	High unemployment reflects underutilization of labor resources and, therefore, correlates with low GDP. Lower unemployment typically correlates with higher GDP due to increased production and consumption.
Government expenditure	Government’s spending on goods, services, and public projects.	Government spending can stimulate economic activity and the GDP. However, too much government spending will cause debt issues and inflation, ultimately lowering the GDP.

Let us talk about interest rates and unemployment rate and their direct effect on 409A valuations. So, when interest rates rise, the availability of loans and other types of credit falls, and as a result, equity investors become even more valuable. So, higher interest rates can give more leverage to incoming investors and cause valuations to fall.

On the other hand, high unemployment results in low labor costs. After all, there will be more competition for the same jobs and companies will have more power in negotiations. Therefore, assuming high unemployment levels do not have any significant impacts on GDP, then there are chances that startups could minimize their expenditure on salary costs.

Thus, they could improve their financials which will improve their valuations.

Example of how macroeconomic conditions favorable to 409A valuation

Suppose you founded a startup called InnovateX a little over a year ago. Since its inception, the economy has improved significantly. The GDP has been on the rise, interest rates are low, and inflation is still moderate.

So, even if your startup did not reach any new achievements, its valuation will still increase since businesses in general are faring better now and why should your startup be any different?

Now, suppose that your product is a necessity. Its demand does not fall when income levels fall. Then, if the economy goes down, it will not affect InnovateX. If the unemployment rate rises significantly, your hiring costs will fall. The government could announce more spending and the central bank might lower interest rates to boost the economy.

If these changes happen, your borrowing costs will fall and when the economy picks up, so will the demand for your product. Such a situation could also increase your valuation.

Effect of Equity Market Conditions on 409A Valuations

By following movements in broad market indices and their valuation multiples, we can gauge investor sentiment toward equity. We can understand the general risk appetite of investors and their level of optimism by looking at equity market variables. Although public equity market conditions may not always directly apply to private equity markets, they are still the closest asset class.

If optimism is growing in public equity markets, the risk appetite of some investors may increase. They may want to invest in private equity investments, either directly or indirectly through funds. In that case, more money would flow into private equity, and valuations would rise.

On the other hand, if equity markets are falling, it will make investors rethink their risk appetite. Since money would flow towards safer assets, private equity valuations would fall.

Example of how equity market conditions can affect 409A valuation

Continuing with InnovateX, suppose public equity markets experience a significant downturn due to a banking crisis. Even if this does not directly affect InnovateX, its valuation will still fall.

Suppose, you are an investor in InnovateX and also have some stock market investments. Then, if the stock market falls, you would want to transfer your money to more secure investments. Since private equity is riskier than public equity, many investors like you will want to transfer their money away from private equity as well.

Thus, the effect of equity market movements on investor sentiments and the flow of funds influences startup valuations.

Effect of Sector-Specific Changes on 409A Valuations

It is quite easy to understand that when a sector goes down, it will impact most of the companies belonging to that particular sector. Every sector in the economy has its unique features and is affected by distinct trends and events.

Let us take the technology sector for example. Here, companies must keep innovating to keep up with evolving consumer and business needs. Additionally, regulatory changes can significantly affect the evolution of this sector.

For example, changes in data privacy regulations would influence the future operations of technology companies and their compliance costs. Another important factor is customer preferences. With changing trends and demands, there are opportunities or challenges for companies. On the other hand, an increased demand for sustainable and eco-friendly products could favor companies in green technology.

Suppose that InnovateX is a technology company with great dependence on the semiconductor chips industry. Over the last couple of years, due to the Russia-Ukraine war, things only got worse for the semiconductor shortage. If the war comes to an end finally and the semiconductor industry can recover, it would be very positive for InnovateX’s valuation.

Navigate Market Dynamics with Eqvista’s 409A Valuations

To help you align your 409A valuations with market trends, we have recounted how different types of market trends affect 409A valuations. We went over how changes in GDP can affect startup valuation and saw how other economic variables affect valuations by first impacting the GDP. Then, we saw how equity market conditions determine the flow of funds and investor sentiments. Finally, we saw some examples of the effects of sector-specific changes on valuations.

Now that you understand the effects of various market trends, you can make appropriate changes to your 409A valuation by simply noting down the changes in market conditions since your last 409A valuation, and then, quantifying their effect on your company’s valuation.

Use our 409A valuation index if you want to compare the market trends for the 409A valuations against the general macroeconomic, equity market, or sector-specific trends.

In case you are at a stage where frequent 409A valuations are a necessity to you, consider Eqvista’s annual subscriptions. We offer accuracy and affordability along with time savings. Connect with our team here to get a quote!