When to get a second opinion on your 409A valuation?
This article will help you to understand the concept of 409A valuation and list down some scenarios when you need to get a second opinion on your 409A valuation.
The IRS’s Internal Revenue Code section 409A is designed to provide private companies with a method to determine their common stock’s fair market value (FMV). As 409A specifies that the FMV must be determined consistently and objectively, companies can hire an independent third party to determine the FMV. While the purpose of the 409A valuation is to establish stock-based compensation, comply with legal requirements, and provide an opportunity to secure funding. Additionally, Section 409A was enacted to prevent private companies from artificially inflating the value of their stock or options. Well, this article will help you to understand the concept of 409A valuation and list down some scenarios when you need to get a second opinion on your 409A valuation.
Understand 409A valuation and how it works
A 409A valuation is a provision of the Internal Revenue Code (IRC) that requires privately held corporations to determine the fair market value of their shares. In other words, it measures the price of the company’s stock at which a willing buyer and seller would agree to trade. The mechanism of 409A valuation is that the company will determine its stock price by using inputs based on financial information and subjective assumptions such as industry profitability, company performance, projected industry growth, and more.
Why should you get a 409A valuation for your business?
In order to comply with the Internal Revenue Code section 409A, companies must get a 409A valuation. The importance of 409A valuation is that businesses can make sure to accurately determine their common stock’s FMV and avoid any unnecessary legal issues. Moreover, the 409A valuation allows you to make a decision for your company’s future in regard to a potential or existing acquisition, stock-based compensation plans, IPO, or any other financial event.
When should you get your 409A valuation?
As we know that the purpose of 409A valuation is to provide a measure of your company’s stock price, which helps you to determine the amount of stock-based compensation, calculate tax consequences, and allows you to secure funding. Stock-based compensation is an important part of any business, especially in the startup phase. In this regard, the 409A valuation allows you to work on your legal strategy and define the scope of stock-based compensation.
Additionally, these reports are sometimes used in establishing the critical parameters of acquisition and negotiating with potential investors, and it also helps you to track your stock’s value over time. Furthermore, when a private company plans to offer an initial public offering (IPO) to the public, the 409A valuation can be used to determine the amount of IPO proceeds under the Securities and Exchange Commission (SEC).
409A valuation guidelines and penalties
In order to comply with 409A and the Internal Revenue Code, the company must complete the 409A valuation each year and file the forms by adhering to the 409A valuation guidelines. The following are the guidelines and penalties for violating 409A:
- IRC 409A guidelines – The guidelines laid down by the IRC for completing your 409A valuation are very comprehensive. The guidelines include full disclosure of the methods used for valuation by independent third parties and a clear explanation of the processes and procedures followed in the valuation process. In addition, companies should make sure that they have a rigorous process of review by the company’s board of directors and be reviewed by an independent valuation expert.
- Consequences of not getting 409A – If a private company fails to get a 409A valuation as required by the Internal Revenue Code, they must be prepared to pay the penalties. The IRC could impose penalties on the employees, company, executives, or even board of directors members with a 20% penalty. So, when do you need a second opinion on your 409A valuation?
When do you need a second opinion on your 409A valuation?
Even though you have conducted the 409A valuation with your internal resources, the company may still need to obtain a second opinion on the valuation. These situations occur when the company has accumulated enough data to determine the FMV of their stock in a timely manner but is unable to accurately arrive at the same number. Here are some of the situations that might require a second opinion on your 409A valuation:
- What invalidates a 409A valuation? – It is common for companies to discover new information or circumstances that invalidate the valuation. Non-realistic assumptions, projections, or other information that invalidates the valuation can change a company’s stock price. Moreover, there are situations where a company could discover that they have made an error in the calculation and they need to adjust the valuation. All of these situations show that the company needs to obtain a new opinion on the valuation and make necessary adjustments.
- How long can you rely on 409A? – Since a 409A valuation is a measure of value, it is generally safe to rely on the results of a 409A valuation until it is invalidated by new circumstances. However, the company should be aware of any changes in the value of its stock price that could potentially affect the results of a 409A valuation. As such, regularly verify that the results of a 409A valuation are still valid. The company can generally rely on its previous 409A valuation for up to one year from the report’s filing date. Although, after every funding round and additional material changes to your company, a new 409A valuation is generally required.
- How often is a 409A required? – Either the company can perform the 409A valuation at the time of funding rounds or issuance of the first common stock options. In the case where both of these events do not occur, every 12 months, you should get a new 409A valuation.
- What triggers a 409A valuation? – During the process of a 409A valuation, the company would usually have to identify significant events that would trigger the need for a 409A valuation. This can include new management changes, significant mergers or acquisitions, internal policies that affect the value of the company’s stock, approval or rejection of a capital raise, changes in the overall financial situation of the business, etc. These situations might trigger the need for a new opinion on the value of the company’s stock.
What things can be considered in the second opinion?
The second opinion on a 409A valuation is generally considered to be an expert estimation of a company’s value. As such, the valuation should be based on what is known or reasonably expected of a company’s operation and growth. However, in some cases, the valuation expert may need to perform a different analysis to arrive at their estimation. Following are some of the things that experts can consider as part of their valuation process:
- Valuation methodology – Before moving forward with the considerations for the second opinion, you should understand the various valuation methods. The income approach is aimed at estimating the value of a share by looking at its future cash flows for the next five years. While the market approach considers the value of the stock by comparing it with the transactions of comparable public companies. On the other hand, the asset approach is based on the value of a company’s assets, including tangible and intangible.
- Acceptable Assumptions in company forecast – Under an income-based approach, relevant assumptions include revenue growth, customer attrition, gross margins, and other relevant market conditions. Projections should be fair and reasonable so that the expert can arrive at a fair market value. As such, second-opinion valuers should be able to calculate and understand the assumptions behind the valuation.
- Market Comparables & Multiples – In the market-based approach, a valuation expert should be able to consider relevant data from the public market. The comparison of private and public companies should be carried out carefully due to the fact that public companies have different corporate structures and regulations, which can result in varying factor trends. While getting a second opinion on 409A valuation, the expert should be able to consider relevant data from the transaction of public companies.
- FMV of Company Assets – The asset approach considers the value of a stock by looking at the fair market value of its tangible and intangible assets. Tangible assets include a company’s inventory, property, plant and equipment, while non-tangible assets include patents, trademarks, and goodwill. Accurately valuing tangible and intangible assets is critical to the process of determining the true FMV. A second opinion must be able to calculate and understand the company’s assets.
- Backsolve Method (VC method) inputs & Modeling – In this technique, the FMV of a stock is measured by considering the most recent price paid for an investment in preferred shares of the startup. VCs generally consider this method an acceptable practice. Since it considers the latest investment, the VCs would use an average price based in order to avoid skewing the calculation. As such, inputs and modeling should be carried out in a manner that would not influence the results.
- Discount for Lack of Marketability (DLOM) – This is the last step of the 409A valuation process because all other factors have been taken into account, where the discount is applicable to the common shares due to the fact that shares of private companies are not publicly traded. It is important to note that the DLOM should be considered a realistic future value for the company. When taking a second opinion on the 409A valuation, the expert must calculate and understand the assumptions associated with the DLOM.
- Consideration of additional premiums/discounts – In certain situations, additional discounts or premiums should be taken into consideration to arrive at a fair market value for the private company. This would include the possibility of a discount for lack of control or lack of marketability. Similarly, factors such as the fact that the company is in a startup stage, lack of consistent earnings, and expert management would normally result in additional premiums. It is essential that the valuation expert consider these premiums and discounts in their analysis.
How to find a reputable valuation firm to give a second opinion on your 409A valuation?
As with any decision, finding a good valuation firm is probably the first thing you should consider when considering the second opinion for a 409A valuation. As such, a good place to start is to conduct an online search for “409A valuation firms” in your area. Eqvista is one of the leading experts in financial services and has an extensive network of qualified professionals who have the knowledge and experience to provide 409A valuation.
How can Eqvista help with your second opinion on the 409A valuation?
Eqvista’s experienced team of financial advisors, who thoroughly understand your situation, can provide you with an accurate second opinion on your 409A valuation. They will apply the latest techniques and share their expertise to ensure that you are getting the most accurate valuation possible. Thus, Eqvista is the best place to get a second opinion on your 409A valuation.
Get your 409a valuation done by Eqvista today!
The need for a second opinion on 409A valuations is important because the process of determining FMV is complex and can be affected by a number of additional factors that are not taken into account. A good second opinion will be able to consider additional factors that are relevant and will result in a more accurate value of private company shares. Get in touch with Eqvista and get a second opinion on your 409A valuation.