How to Read an Eqvista 409A Valuation Report

The concept of valuation has been widely used in the world today. The significant elements impacting the valuation of a controlling interest in a corporation are asset values and earning capability. These days valuation has become extremely important as it helps to drive fair market value (FMV). Similarly, a 409A valuation is used by the companies to get an honest assessment of their company stock. In this article, we explain how to read a 409A valuation report for you to understand your company’s fair market value, and other financial analysis.

Why Get a 409A Valuation?

A 409A is used to calculate the fair market value of your company’s common stock. The special price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409As. When awarding private stock options, privately held corporations might employ the 409A framework. Equity-based awards must be awarded at or above FMV at grant date under 409A.

Additionally, a 409A valuation is required by tax laws. To guarantee that your organization complies, you’ll need a 409A valuation. Non-compliance can lead to disastrous results. Stock option undervaluation can result in significant penalties from the Internal Revenue Service (IRS) and missed compensation. The 409A valuation has been used by companies more often now, and various third parties can actually help in getting a 409A valuation.

When should you get a 409A valuation for your company?

Finding the right time to get a 409A valuation can be tough. It depends on what’s going on at your company, such as financing or employing equity-based staff. If you acquire a 409A valuation too soon, you’re wasting valuable early-stage cash on a service that will almost certainly cause you unnecessary struggles. If you get a 409A too late, you risk selling underpriced options, which could result in hefty IRS fines. The company must plan on getting a 409A valuation when they are planning to keep stock options or undergo a material event. The material event can be the following:

• A qualifying round of funding (you sell common shares, preferred stock, or convertible debt to outside investors)
• Set up of employee stock options
• Acquisition of a new business
• Another company’s acquisition
• Common stock is sold in secondary markets
• Changes to your business model or financial assumptions that are significant

Reading a 409A Valuation Report

Reading a 409A valuation report means identifying the share price or exercise price for stock options and share offerings. A 409A valuation report determines the fair market value of a private company’s common stock provided by an independent appraiser. Private corporations can use 409A valuations to comply with section 409A of the IRS tax law, which governs non-cash compensations (stock and option grants).

What’s included in a 409A valuation report

At fair market value, a 409A valuation is an impartial evaluation of a private company’s common stock or equity reserved for founders and workers. This valuation determines the cost of purchasing a share. The special price for options granted to employees, contractors, advisors, and anyone else who receives common stock is determined by 409A valuations.

Summary of findings

As the name suggests, the summary of findings section will contain the fair market value (FMV) of your company’s common stock. Since valuation figures are influenced by valuation methodologies and assumptions, we indicate the locations of the Statement of Assumptions and Limiting Conditions and the Valuation Analyst’s Representation in this section.

In this section, along with the FMV, we also mention the purpose and scope of the report. Most 409A valuations can only be used for financial reporting and for issuing stock-based compensation in a tax-compliant manner. Here, we will also mention the accounting and valuation professional standards that were followed to prepare the 409A valuation report.

Since 409A valuations from independent valuation experts can help companies get safe harbor protection, we are required to disclose if we have any connection with the company being valued.

Introduction

The introduction starts with a reference to the revenue ruling that established the definition of fair market value (FMV). Then, we talk about the nature of the stocks and their options to understand how they should be valued. We will also mention if the company was valued as a going concern or as if it was being liquidated.

In the case of an IRS audit, it is necessary to be completely transparent about the information and methodologies used. Hence, we also mention the sources used.

After this, we also attach an overview of IRC Section 409A for your understanding.

Overview of Valuation

In the overview of the valuation section, you will find the value of each equity class, the valuation from all the approaches that were applied, and the discount for lack of marketability.

Corporate Profile

The corporate profile includes an overview of the company and its capital structure. The company overview will contain details about when the company was founded, who it caters to, a description of its products, and various other important details. The capital structure is represented in the form of a table showing units held by and the fully diluted stake of each equity class.

Industry Overview

When we compile an industry overview, we will cover the general industry your company is operating in and the market segments it is targeting. This industry overview will include factors such as the expected growth rate and relevant trends, including demographic and economic trends, and trends in other industries.

National Economy

Typically, the national economy overview covers the ongoing economic cycle in the country. It will cover details like gross domestic product (GDP) growth, inflation, unemployment rates, and interest rates. We may also cover the reasons behind the ongoing economic conditions.

Valuation of the Company

The valuation of the company is preceded by an overview of the valuation methodology and a recap of the valuation approaches. The valuation methodology overview will outline the factors considered in the valuation process and how they were incorporated. The recap of valuation approaches, which describes the market, asset-based, and income approaches, is meant to help you interpret the results of the valuation report.

In this section, we explain why we adopted or rejected certain valuation approaches.

Results from Each Applicable Approach

After we have explained the valuation methodology and the approaches being applied, we will show a summary of the valuation process itself. In this sample report, we only needed to show a summary of the market approach to valuation. However, if other approaches are also adopted, we will show a summary of them too.

Reconciliation of Value

When multiple valuation approaches are utilized or a privately held company is valued, it is necessary to summarize the valuation process to derive the fair market value (FMV) of the company. At this stage, we will also apply the discount for lack of marketability.

Allocation of Equity

Now that you know the value of your company, you must understand how the value is allocated to different equity interests, including the stock options. So, in this section, we cover the recommended methods for allocation of enterprise value to all security holders. Then, we will explain the method we chose to allocate enterprise value. The details of this process are mentioned in the appendix.

Conclusion of Value

In the next section, we mention the fair market value (FMV) of the common stock.

Premiums and Discounts

The final value of a company may differ from the value established in a valuation approach because premiums and discounts are applied to account for factors such as competitive advantages or lack of liquidity. In this section, we introduce this concept in brief. Then, we note the different discounts and premiums that were actually applied.

In this case, only the discount for lack of marketability was applied.

Assumptions and Limiting Conditions

In this section, we state all the assumptions that were used as inputs in calculating the value of your company. We will also note the limitations on how the report can be used. This section includes important points regarding the level of confidentiality and the boundaries of responsibility for the valuation service provider, namely us, Eqvista.

Valuation Analyst’s Representation

The purpose of this section is to state the nature of engagement between Eqvista, the valuation analyst, and your company. This section will include declarations of no recent involvement with your company, disclosure of independence from the parties involved, and affirmations for the accuracy of the report.

Appendices

The appendices will contain the following information:

• Guideline company information such as product portfolios, trading multiples, and financial information.
• Financial statements of your company.
• A summary of the process followed to allocate value to different equity interests, in this case, the option pricing model.

How Does a 409A Valuation Report Help You?

When it comes to valuing private shares, the report provides a structure for private corporations to follow. When an unaffiliated or independent entity does the valuation, it creates a safe harbor, which means the IRS will assume the report is “reasonable”. It also determines:

Determining FMV of Common Stock

You can immediately see the price of shares on the open market when calculating the value of a public firm stock by going online. Private corporations, on the other hand, are unable to do so. With a 409A valuation, private firms must first assess their common stock’s “fair market value” (FMV). The recognized current worth of one share of a private company’s common stock is known as fair market value. It shows how much the store would be worth if it were traded on the open market. This is not to be confused with “post-money valuation” which is the market value of the entire business.

Determining Strike Price of Options

What price do you think the underlying stock will go to over a particular length of time, and what price are you ready to pay or get for purchasing or selling an option contract? The 409a valuation would also be able to determine the value of your stock options, and in turn their strike price, for issuing shares or even stock option expensing.

Protection from IRS Penalties

Without a 409A valuation to determine your company’s FMV, you risk getting penalized by the IRS when the share value is not properly valued. It’s important to get a valuation to determine the FMV to avoid penalties. Some IRS penalties include:

• Deferred compensation for the taxable year
• 20% penalty tax on the deferred amounts
• Income inclusion at the time of vesting even if the benefit has not yet been paid
• Increased interest rate on the late payment of the income tax due to compensation

Get a 409A Valuation Report For Your Company

Eqvista provides the most accurate and high-quality 409A valuation report. Our report includes all essential information, including the FMV of the company’s shares, the methodology we employed, and how we examined everything. You’ll be able to find out everything you need to know about the company, from its capital structure to its industry.

If you’re looking for a 409A valuation report to use when issuing options to your employees, don’t hesitate to get in touch with us.