A 409A report, which provides a fair market value for a company’s common shares, is created by 409A valuation providers. At Eqvista, our highly experienced team of analysts assists all sorts of companies to determine their firm’s value by meticulously evaluating their financial data. To help you understand 409A valuations, we have put together advice from 409A valuations experts to explain why getting one is important.
1) What is a 409A valuation, and why should I get one?
A 409A valuation determines the fair market value (FMV) of a private company’s common stock or equity reserved for founders and employees. In other words, this valuation determines the cost of purchasing a company’s share. When awarding private stock options, privately held corporations might employ the 409A framework. Equity-based awards must be awarded at or above FMV at the grant date under 409A.
Deferred compensation is governed by Internal Revenue Code (IRC) 409A, which requires a valuation each time you plan to give out shares in your company over a period of time. The rules for determining your common shares’ FMV are found in IRC 409A.
2) Can I do a simple valuation for my small startup?
For many startups, getting a 409A valuation may be costly and most business owners may not want to deal with complicated paperwork. However, it’s important for any business to get a valuation in order to avoid having problems with the IRS later on.
You can consult with a valuation firm on how the valuation of your startup will be conducted. At Eqvista, our valuation team will guide you at every step and the process will be streamlined. Whether you are a startup or a big company, you should get a 409A valuation because:
- It sets the strike price of your company.
- It is proof that the strike price is right as per the rules set by the IRS.
- It offers safe harbor status (meaning the valuation is presumed to be correct because it was done with the proper methods).
- If the valuation is not done, your company could incur penalties and extra taxes.
3) How often should I get a 409A valuation?
Business owners do not want to get into trouble with the IRS over their taxes; it would be disastrous for the company. However, sometimes there are many important business matters to take care of that business owners may overlook their company’s tax problems. Still, it’s important for business owners to have a 409a valuation for their company. Here’s when you should get a 409a valuation:
- Once every twelve months
- Any investment made on new terms is unquestionably a substantial event. Your company’s value, as determined by independent investors, is now different than it was previously. If you want to issue options, you’ll need a new 409A.
- M&A activity: You purchased a business. Even if it was an acquihire or something similar, you still bought a business. It’s time to get a new 409A.
- A significant shift in your company: Your revenue hasn’t changed, but you’ve switched from consulting to creating a SaaS solution. We’ll use a different multiple for advisory services and SaaS when valuing your company.
In a nutshell, the valuation should be done every 12 months. This would allow you to focus more on your business and perhaps help it grow. It would also assist you in avoiding any IRS problems.
4) Cost & Time Frame of Getting a 409A valuation
Depending on the company’s size, many 409A valuation providers charge anywhere from $1,000 to $10,000 for their services. It may be costly, but keep in mind that there are valuation firms that offer high quality service at a low price. Some may have less expertise and no credentials yet charge a bigger price for their services.
Make sure the valuation firm has the necessary certifications and expertise. Eqvista, which has NAVCA accreditation and experience with over 5,000 clients, offers 409A valuations for companies starting from $990. The 409A valuation report is valid for 12 months or until the firm undergoes a major event, such as an IPO, fundraising round, or acquisition. If a material round occurs, you will need to have your firm valued once more.
5) How is a valuation calculated?
A valuation is usually calculated using three different methods: Asset Approach, Income Approach, and Market Approach. These methods are one of the most common ways to conduct a valuation of a company.
- Asset Approach: Mostly used for very early stage business, this the least common and supported 409A valuation method. This is mostly used for businesses that have not raised any funding and do not have any revenue yet. It calculates the net asset value to determine the value of the business.
- Income Approach: This approach is used for companies with positive cash flow and sufficient revenue. A company is valued at the present value of its future earnings or cash flows (which are determined by projecting the earnings of the business and adjusting them for changes in taxes, cost structure, growth rates, etc.).
- Market Approach: This method is used when the business has just raised equity funding. It compares your company with other comparable companies that have been sold in the market in order to determine the fair market value. In this case we say similar, because many of our clients may not have a similar public company as there’s’, but still close enough for us to gather relevant data for the market approach.
6) How to calculate FMV of my shares?
409A valuations determine the fair market value of your common shares. In other words, they set the strike price at which employees, contractors, and anybody else who receives common stock must pay to exercise their stock options. The strike price must be equal to or more than the 409A valuation’s FMV. When determining the value of your business, 409A providers typically consider the following factors:
- What your assets are worth?
- Your cash flow’s current value?
- The value of the common stock to similar companies?
- What percentage of your company’s stock is invested at?
7) What is DLOM? Why should I apply for it?
When valuing private companies, the discount for lack of marketability (DLOM) is applied. It has to do with the fact that the company isn’t listed on a stock exchange. Because shares can be purchased and sold in a controlled marketplace, publicly traded corporations are thought to have a “market”. Private enterprises lack a centralized market and are thus believed to have a smaller market.
As a result, private companies should, in theory, be valued lower than public companies if all other factors are equal to reflect the lack of a market. Due to a lack of information – most notably, pricing information – analyzing private companies is a difficult task for analysts.
Here is a table by industry of the DLOM’s our clients typically see:
It’s common knowledge that selling a stake in a private firm is more expensive and time-consuming. Selling a stake in a private company comes with a lot more risk, as well as the uncertainty that comes with discussions. In order to avoid these confusions and find a suitable DLOM, it’s advised to seek guidance from an expert.
8) My valuation seems too high/low. What should I do?
It’s important to have a valuation that’s ‘just right’. This means the valuation can’t be too high nor too low. A good valuation is often a compromise, and most leaves you with an acceptable valuation which is also defensible in the eyes of the IRS.
However, there may be instances that your valuation may be too high or too low. This can lead to several problems for your company:
- If the valuation is too high:
- It might lead your company to short-term gain, but it can do large damage in the long run. You may need a high valuation for investment purposes, but you could be paying a lot of backend taxes as a result of your share value.
- It raises the stakes for future rounds and leaves you with little room for error.
- If the valuation is too low:
- Your company will have trouble raising funds in the future
- Investors might not be interested in your company
- Higher chances of an audit by the IRS and extra penalties & taxes
Either way, having a high or low valuation may lead to having the wrong kind of investors for your company. To guarantee that your valuation is just right, it’s better to consult with a valuation analyst to determine which valuation method is the best for your company.
Why Choose Eqvista as your 409a valuation firm?
Eqvista offers 409A valuations that can be audited. We execute over 50 409a valuations and audits every month, making us one of the largest cap table management and 409A service providers. We use best-in-class software and industry experience to give appraisals that are both faster and less expensive than those provided by traditional sources. If you have any issues or require a 409A valuation, contact us today.