How to Read a 409A Valuation Report
Reading a 409A valuation report means identifying the share price or exercise price for stock options and share offerings.
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 / Valuation Overview
The conclusions will be discussed in this section of the 409A valuation report, and the value for the common stock will be presented. This is usually the portion that the company’s management is most concerned with. The following sections, on the other hand, are critical in making the IRS 409A valuation auditable.
The valuation shows the details of the valuation methodologies employed and the final result. It also shows the differences between each method’s output, such as the asset, income, and market approaches.
Company background & Capital Structure
Company background is fundamental as it provides information on the company and its history.
The capital structure includes information on the company’s cap table. This section uses tables and charts to help you comprehend the company’s capital structure. The many types of equity securities and classes that make up the company’s ownership.
Financial analysis is used to make various financial decisions related to the stock, equity, shares, revenue, profit, and losses incurred. It is a process in which the company’s financial position is analyzed for the valuation. The company’s financial analysis, based on the income statements and balance sheet, which were provided in the preceding sections. It would also include financial statements of a standard size in comparison to others in the industry.
Valuation Methods Used
There are various methods to determine the valuation of the business and it is used in the same way in 409A valuation. The plans are as follows :
- Income Approach – A business is valued using the income technique at the present value of its future earnings or cash flows. This and along with the values from the other methods, are used to calculate the company’s final value. The income approach assumes that a property’s current full cash value is equal to the current value of future cash flows it will generate over the course of its remaining economic life. It is a traditional method of appraisal, but it requires a great deal of research and study. Because it relies on so many assumptions, the income valuation technique has the highest model risk – the risk that your model will turn out to be incorrect.
- Market Approach – The market value business valuation formula is possibly the most subjective method of determining the worth of a company. This strategy compares your firm to similar businesses that have sold to evaluate its worth. The usage of real estate comparable is analogous to the market value approach. This method is based on a sales analysis of similar properties and determines full cash worth by examining recent sales or offering prices of comparable businesses to find a multiple. If similar transactions are not identical to the subject business, the comparable property’s selling price is adjusted to account for the variances.
- Asset Approach – According to your balance sheet, asset method examines your company’s total net asset value less the value of its total liabilities. The cost method is based on the logic of the substitution concept. A costing method to value has two alternative beginning points, similar to the market approach: reproduction cost and replacement cost.
Once the company’s total value is determined, we run a waterfall analysis model to determine how much each of the company’s equity classes is worth, be it the common stock, preferred stock, stock options, warrants, or other classes of shares.
Discounts for Lack of Marketability (DLOM)
The approach used to evaluate the value of closely held and restricted shares is known as discounts for lack of marketability (DLOM). The assumption behind DLOM is that there is a valuation discount between a publicly listed stock, which has a market, and a privately owned stock, which frequently has little or no market.
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 harbour, 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.