Top Reasons SMBs Require 409A Valuations

Suppose you own a small or medium-sized business. In that case, understanding SMB valuation is crucial for you to make informed decisions, secure financing, and plan for the future of the business.

As a business owner, understanding SMB valuation is not just a theoretical concept. It’s a practical tool that can empower you to make informed decisions, secure financing, and strategically plan for the future of your business.

Factors like financial performance, industry trends, and intangible assets like brand reputation are necessary to prepare for SMB valuation. Understanding these comprehensive factors may take work. It’s completely understandable if you need help figuring out where to start. In such situations, seeking the guidance of a professional valuation service can be immensely helpful. We created this article to help guide you through the process of SMB valuation.

SMBs 409A valuation

A 409A valuation of SMB sets the strike price for common shares typically awarded to employees as part of ESOP (employee benefit plan). While businesses often undergo various valuations, the 409A valuation is specifically for establishing safe harbor status with the IRS.

Grasping the importance of 409a valuations not only helps you know the “strike price” (the price at which the employees can buy the stock) of your company’s stocks but also benefits you in determining:

• The FMV of stocks
• To attract talent
• Measuring the company’s growth
• To make informed business decisions

A valuation carried out by an independent third-party valuation team to define the strike price of the employee stock option is known as 409A Valuation for SMB.

Lets understand this with the help of a simple example of SMB Valuation using the Multiples method. For instance, let’s say a manufacturing SMB has an annual revenue of $2 million and the industry average EBITDA multiple is 5x.

To calculate the business value using this method:

• Identify the relevant financial metric -In this case EBITDA
• Determine the appropriate industry multiple -the average EBITDA multiple is 5x here
• Now multiply financial metric by industry multiple:
  • EBITDA – $200,000
  • Industry EBITDA multiple – 5X
  • Estimated Business value – $200,000 x 5 = $1M

This multiples method provides a market -based valuation that can be compared to other approaches, to arrive at a comprehensive assessment of the worth of SMBs.

Understand SMBs 409a valuation

A 409a valuation determines the strike price of the company’s common stocks—more specifically, the value of your company’s share (Stock). Before giving your employees equity, you should know what price to put in place. As the market decides stock prices for publicly traded companies, private limited companies will require the 409a valuation to know the stock price.

An independent expert will do the 409a valuation for SMBs. This valuation report will also be useful during M&A transactions and when your company goes public.

Additionally, the SMB valuation highlights the company’s stock potential, which helps attract talent. Top talents often seek opportunities where they see rewards for their efforts. This report will also help make an informed decision and measure the company’s growth potential.

Reasons SMB requires 409a valuation

The following are the common motives behind performing a 409a valuation for SMBs.

Compliance and Legal Requirements

First, the basic reason for doing a 409a valuation for SMB is to comply with the law. Section 409a of the Internal Revenue Service (IRS) requires you to conduct a 409a valuation to ensure that issuing equity to employees has a fair price attached to it.

Getting a 409A valuation for SMBs is a regulatory step. Not aligning these values can lead to the risk of non-compliance with the 409a valuation for SMBs and heavy penalties from the IRS. So, if you’re considering providing equity, this valuation is your first step toward a clear and compliant equity plan.

Remember that a 409a valuation for SMBs is not a one-time thing. You must do the valuation at regular intervals to reflect your company’s correct stock value.

What happens if you are not in compliance with the IRS regulations? If your SMB does not comply with the IRS regulations on 409a valuation, it will be outside the “safe harbor,” and employees and shareholders may have to pay hefty penalties. Employees should pay income tax and a 20% federal penalty in cases of incorrect pricing.

Stock Option Pricing and Equity Compensation

An accurate SMB valuation can help determine stock option prices, which can help provide equity compensation to employees.

How do 409a valuations help determine the FMV of stocks?

We know an SMB’s Fair Market Value (FMV) can be determined using the 409a valuation. And yet, how exactly does it do this? In 409a valuation for SMB, there are three common approaches for calculating the value of a share. Here they are:

• Market approach – When using the market approach, you have to compare the target company with similar publicly traded companies and determine its value using valuation multiples such as Revenue or EBITDA.
• Income approach – If your SMB valuation has steady and predictable cash flows, consider using the income approach. This approach uses the Discounted Cash Flow (DCF) model to forecast and discount future earnings to their present value.
• Asset approach – Companies in their early stages or with a large amount of assets can use the asset approach, which calculates the value by adding the total assets and deducting it from the company’s liabilities.

As a small business, you may not have enough investments to pay for skilled employees, but you will need them for the company’s growth. In that case, providing shares as part of equity compensation is the smart choice. 409a valuation for SMBs helps with accurate stock prices. It also encourages employees to work towards the company’s goals as they share ownership when they know they receive fair value for
their contributions.

Retaining top talents in the company

Often the unsureness of stock value causes a risky position for the company in retaining the top talents in the company. If your SMB valuation is high, you can provide employee incentives such as stock options or grants. This encourages them to stay and contribute to the business, increasing the company’s overall performance.

Also, a high SMB valuation increases the ability to offer a competitive compensation package. All the competitive salary packages in the market often include stock options, So if you’re missing out on a 409a valuation for your SMB, you will be missing out on one of the attractive elements in retaining the top talents in your firm.

Funding and Investment Purposes

A 409a value is important for SMBs to attract investors. With your SMB valuation report, you can show investors that your company has growth potential, which will increase their interest in investing.

Investors look at your stock’s price to assess a startup’s potential worth and expansion. Before an acquisition or funding round, an accurate and up-to-date valuation is essential. Founders and investors might use it as a benchmark for negotiations.

An accurate 409a valuation for SMBs can help in two important ways:

• To have a fair negotiation – you should have sufficient startup capital for your SMB valuation . During this stage, angel investors and VCs will use your 409a valuation to assess your potential. They can determine the amount of investment they can make in return for shares and calculate their Return On Investment (ROI) with the help of 409a valuation.
• To create credibility – stakeholders have faith in the company’s honesty and transparency when they see a reasonable 409a valuation for SMBs and feel they’re getting a fair amount of equity pay.

Mergers, Acquisitions, and Exits

For an SMB, there can be situations where your company might go through Mergers & Acquisitions (M&A) transactions or go public. An accurate stock option valuation can help you get the best deal in both scenarios.

During an M&A or exit, a 409a valuation for SMBs ensures a good deal. In these scenarios, the buyer and seller must agree on the target company’s fair market value (FMV).

Below are a few other important reasons to have 409a valuation during M&A and exits:

• Transparency – 409a valuations are open and transparent, creating stakeholder trust and confidence. By providing an accurate valuation report during M&A and exits, the concerned people will know what they are dealing with, ensuring integrity in the final deal.
• Risk mitigation – Similarly, an open and well-documented SMB valuation will reduce uncertainty and mitigate transaction risks. The parties involved are well-informed about the SMB’s financial status, which minimizes the chances of disputes.

Strategic Decision-Making and Financial Planning

If you own a small or medium-sized business, you should get a 409a valuation to plan your finances and make smart decisions. A 409a valuation could provide useful information for decision-making and planning purposes by showing the market worth of the company’s shares. For SMBs, there are several ways the 409a valuation might be useful.

The stock value of your SMB (409a) is more of a snapshot in time. Calculating its stock’s value can help you better comprehend your company’s performance. Your company will thrive in an environment of consistent strike prices and vice versa.

An accurate 409a value is required for SMBs to set reasonable goals. To improve, you must first be conscious of your current situation. Furthermore, by doing a 409a valuation for SMBs, you can identify issue areas and implement remedial actions.

Why should you seek professional help for SMB 409a valuation?

Precision is key when valuing a firm. But there are some key challenges in valuing SMBs, such as lack of information ,unique characteristics of business, difficulty of applying valuation approaches,lack of marketability and concentration risks. Addressing these challenges requires valuation practitioners to carefully select the most appropriate methods, adjust formulas and gather comprehensive information.

It’s important to keep in mind that 409A valuations must comply with IRS regulations to avoid potential audits and penalties. To ensure that your small or medium-sized business receives an accurate valuation, it’s best to work with qualified firms like Eqvista.

The experts at Eqvista understand the complexities involved in 409A valuations and have served 14,000 clients. We want to help make this process as stress-free as possible for you and your team.

A certified expert must conduct the valuation to ensure credibility and acceptability to the IRS. These specialists will adhere to the proper valuation approach to give stakeholders a trustworthy report.

How can Eqvista help with your 409a Valuation?

With everything said, you will now understand the importance of a 409a valuation for your SMB. As it has complex dealings with the company’s concepts, different methodologies, and more, seeking help from a professional is a good choice.

A 409a valuation for SMBs generally requires gathering data, including past financial statements, market data, and business predictions. Our valuation services make this process easy. Eqvista can help ensure that your 409a valuation aligns with IRS regulations. Our affordable startup valuations starting at $990.

In addition, our valuation expert can help you with all 409a valuation-related activities. Contact us today to learn more!