409A Valuations: Everything that Executives Should Know

A 409A valuation determines the fair market value (FMV) of a private company’s common stock as determined by a third-party appraiser. Startups require 409A valuations in order to provide employees tax-free stock options. The 409A valuation defines a company’s common stock’s base price, which is used to determine the price at which workers can exercise their stock options. The main distinction between 409A valuations and financing round valuations is that 409A prices are not based on market demand.

409a valuation for your business

While it is simple to check the price of a publicly-traded stock, a private corporation would require an independent appraisal to know how much its shares are worth. Because the value of a private company’s common stock isn’t readily available because it isn’t listed on a public stock exchange, a 409A valuation is required. The IRS has published regulations requiring that FMV be determined using a “reasonable method” at the time of the award. Using an independent third party to calculate the FMV of a company’s common stock every 12 months is one approach for the firm to ensure that the stock’s value is assumed to be “fair” by the IRS. 

What is a 409a valuation?

The fair market value of the company’s common shares is determined using the 409A valuation. As a result, if the startup grants stock options with an exercise price equal to the fair market value of each share of common stock as determined by the 409A valuation and follows certain other rules, the burden of proof shifts to the IRS to prove that the stock options exercise price was not at least at fair market value.

Why is a 409a valuation important for a business? 

A 409A valuation sets the striking price for stock options granted to employees, contractors, advisors, and anybody else who obtains common stock. A company’s post-money value is often (but not always) different from its 409A valuation, which is based on how much investors paid for their own position after fundraising. Because preferred stock is provided to investors, a post-money valuation is based on preferred stock price, whereas a 409A is based on common stock price. Due to specific qualities, preferred stock is typically more valuable than common stock.

• To determine the FMV of stock price – A company’s post-money value is often (but not always) different from its 409A valuation, which is based on how much investors paid for their own position after fundraising. A post-money valuation is based on the price of the preferred stock because it is distributed to investors, whereas a 409A is based on the price of common stock. Due to specific qualities, preferred stock is typically more valuable than common stock.
• To maintain safe harbor status – Contributions made under the safe harbor must be made for the whole plan year. If the company is operating at a loss for the plan year, or the mandatory safe harbor notice distributed prior to the start of the plan year included a statement that safe harbor contributions could be eliminated mid-year, safe harbor 401(k) plan sponsors are permitted to suspend safe harbor contributions mid-year.
• To determine enterprise value – Take the current share price for a public company, that’s a market capitalization to determine enterprise value. Subtract available funds from outstanding debt. Acquisition prices are frequently determined using enterprise value.
• For M&A – The buyer will look over your 409A valuations during M&A due diligence. In general, bad 409A procedures come across as sloppy, and they won’t help you set the tone for talks. If the buyer is unhappy with the 409A valuation(s), they can change the terms of the transaction so that they are not responsible for any financial burden associated with the mispriced options, they can demand that you indemnify them for the risk, or they can demand that you pay (or force your employees to pay) any associated penalties and taxes related to the affected option grants.
• For funding – The IRS requires private corporations to do a 409A valuation to determine the value of any equity they issue or offer to their employees. A corporation wants the 409A to be below so that employees have more off-site options but not so low that the IRS doesn’t think it’s acceptable.
• To grant stock options – A stock option grant is a chance for an employee to purchase shares in the company for which they work. The market price usually determines the grant price at the time the grant is offered.

How does a 409a valuation work?

The money is usually raised by issuing preferred shares, which have more rights (such as liquidation preference, participation, and so on) than common shares held by a minority shareholder. As a result, the funding price is significantly higher than what a 409A valuation would find, and the firm would make the option price non-lucrative for the employees by using the funding price. As a result, it is recommended that the corporation obtain a second 409A valuation, which would assure compliance and accurately reflect the business risk from the perspective of minority common shareholders.

Things that every executive should know about 409a valuation

In reaction to the perceived abuse of deferred compensation agreements, Section 409A of the Internal Revenue Code (Section 409A) was enacted in the wake of numerous major business scandals at the time.

• Safe harbor 409a valuation how does it help get rid of penalties – Penalties are imposed in cases where the value is not completed in accordance with the 409a valuation law. Employees and shareholders will be the ones who will pay the price. In the event of non-compliance, the IRS can levy an additional 20% tax on deferred compensation, as well as take other drastic measures.
• Penalties if not get safe harbor 409a valuation – However, Section 409A severely restricts a taxpayer’s ability to manipulate the timing of when to recognize income after a legally binding right to compensation is created (whether by delay or acceleration), and as a result, a stock option that is inadvertently granted with an exercise price that is less than the grant date fair market value is subject to severe penalties (FMV)will almost certainly fail to comply with Section 409A.
• FMV calculation with 409a valuation – The FMV would simply be the enterprise value divided by the fully diluted shares outstanding in the case of a corporation with solely common shares (very rare for a privately-held, venture-backed company). Most privately held venture-backed companies, on the other hand, have at least two, if not more, stock classes (for example, Series A/B/C/D/etc. preferred shares in addition to common shares). In many circumstances, calculating the FMV of common shares necessitates additional research.
• Required time to get 409a valuation – The 409A valuation is assumed reasonable if the stock was evaluated within 12 months of the relevant option grant date and no material change occurred between the valuation date and the award date. If these conditions are met, the IRS has the burden of proving that the valuation is “grossly unjustified”.
• 409a valuation methodology – A 409A valuation uses several approaches to determine the fair market value of your company’s common stock, which are as follows:
  • Income approach – The income technique, also known as the discounted flow method, analyses the company’s long-term financial projections to determine expected income levels, which are then discounted back to present value.
  • Market approach – The company is compared to a group of publicly traded companies in its industry that are similar to it. This appraisal aids us in arriving at a quantitative figure for the company’s worth. In other words, it’s a road map for firms to follow when it comes to valuing their private shares.
  • Cost approach – To establish the enterprise value of a corporation, this method employs replacement costs or the appraised value of all of the company’s assets and liabilities.
• Estimate the FMV of common stock – The 409a valuation is a third-party assessment of a firm’s common stock to estimate the cost of purchasing one company share. This appraisal is based on the current market value (FMV). It’s a paradigm that all private enterprises should use when analyzing their own stock.
  • Option pricing method (OPM) – The value of an options contract is determined by allocating a premium depending on the probability that the contract will expire in the money (ITM). Common shares would have significant value under this method solely to the extent that residual equity value remains after the preferred stock’s liquidation preference is satisfied at the time of a liquidity event. The OPM often uses the Black-Scholes Option Pricing Model to price the various call options.
  • Probability weighted expected return method (PWERM) – The Probability-Weighted Expected Return Method is a multi-step method for estimating value based on the probability-weighted present value of distinct future scenarios. First, the valuation expert consults with management to evaluate the range of possible future outcomes for the company, such as an IPO, sale, dissolution, or continuation of operations until a later exit date.
  • Hybrid method – The PWERM and the OPM are combined in the Hybrid Method. It employs probability-weighted scenarios, but it assigns importance to one or more of them with an OPM. When a corporation has visibility into a specific departure path (such as a strategic sale), yet there are still uncertainties, the Hybrid Method may be used if that scenario fails. In this example, a PWERM with a probability assumption that the sale will go through might be used to estimate the value of the shares under the strategic sale scenario.
  • Current value method – The Current Value Method subtracts the worth of the preferred classes based on their liquidation preferences or conversion values from the company’s total equity value on a controlling basis (assuming an instant sale). The remainder is subsequently distributed to common stockholders. Because the CVM is solely concerned with the company’s worth on the valuation date, it is unnecessary to make assumptions about future exit events and their timing. This method has the advantage of being simple to implement and not requiring a large number of assumptions or extensive modeling.
  • Use of Discount 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. According to the restricted stock technique, the only difference between a company’s common stock and its restricted stock is the restricted stock’s lack of marketability. As a result of this lack of marketability, the price difference between the two units should arise. The IPO approach is based on the price differential between pre-IPO and post-IPO shares. The DLOM is calculated using this method as the percent difference between the two prices. The price of the option and the strike price of the option are the determinants of the DLOM in the option pricing approach. The DLOM is calculated using the option price as a percentage of the strike price.
• Required documents for 409a valuation – There are several documents that you need to prepare for a 409a valuation:
  • Basic information about your business, including corporate documents like your Articles of Incorporation and bylaws. You’ll also need to give a copy of the updated and restated Articles of Incorporation if you’ve made any changes to your Articles of Incorporation (for example, adding classes of shares).
  • You’ll also need to include management bios as part of your company information. Put them in writing or include a link to your website’s management biography section.
  • Your appraiser will also want to acquire some general facts about your business, such as its history, industry, revenue sources, and significant rivals’ names.
  • If you’ve already had a 409A assessment, the appraiser will need to go over any previous IRC Section 409A appraisals.
  • A copy of your company’s cap table
  • A year-to-date income statement for the period ending on the valuation date is required for every company (including new corporations).
  • A balance sheet as of the valuation date must be provided.
  • A sample balance sheet will also be required.

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