If you are an investor, then valuation is a term that pops up in every investment you make. Till now you must know what a valuation is and how it works in relation to your investment. You also know the importance of valuing an investment and there are many ways we can value a company. One of those methods is called a 409a valuation. But what is a 409a valuation? A 409a valuation is an appraisal of the fair market value of private business shares.
The valuation derives from the price of each individual share. Non-qualified deferred compensation is regulated by the internal revenue code section 409a. The section regulates how a business treats the compensation given to employees. Usually, the 409a valuation is done in order to assist existing and new businesses to set a strike price that is reasonable for the share options they issue. The options have to reach the fair market value of the shares or higher. It is best to hire a professional to conduct this task for you.
409a Valuation Date
Learn below what is a valuation date in 409a valuation and why you need a 409a valuation for your business.
What is a valuation date in 409a Valuation?
The time the business being valued is assigned a value (price in $) is a valuation date. The term “valuation date” is used when an asset needs to be valued before it is sold/distributed, or the worth of the asset is periodically estimated for reporting. As per the IRS, the 409a valuation process requires a valuation date. The valuation date is not the same day as the report delivery of the 409a valuation.
When do you need a 409a valuation?
Confused about getting a 409a valuation? Or maybe don’t know if a 409a valuation is the best option for you? Let us take a look at this with the help of an example.
Suppose you just began a startup and have managed to attract top-notch talented employees that have years of experience. Still, as a startup, you are experiencing various common issues a startup faces. One of them is that you do not have enough cash to pay your employees high salaries. Instead of paying cash here, you have the option to offer them share and stock options in the business.
This offer is referred to as non-qualified deferred compensation in section 409a. When you decide that you are going to offer our employees shares or stock options to the employees in your company, that is when you need to do a 409a valuation. A 409a valuation at this stage is done to adhere to the federal tax code and to derive the strike price for the shares and options.
Choosing a valuation date for 409a valuation
Choosing a valuation date requires you to consider many situations. This is so as each of the situations can affect the valuation. Some of the questions to ask yourself for different situations are:
#1 When you close a recent funding round
One question you need to ask yourself in case you are choosing to fund your business with venture capital is when you close your recent funding round. Generally, the valuation date will be the same as that day or just after, as you will have all the data that you require for the valuation of the firm. A major benefit offered by this method is that it eases the process of valuation. But this can also act as a disadvantage in many ways.
The point being made here is that by imputing the value of regular shares on a recently priced preferred share, you leave less to no room for any assumptions or judgments. The whole thing becomes formulaic. But this method can be good and is the preference of a majority of investors to value firms. If the valuation is done right and immediately after the rounds, it is a good sell. But as more and more time passes from the funding round, the chance of things changing increases. This is so because since the funds were invested in the company, things change, and so will the price of the shares and options.
#2 End of an accounting period (if there are no funding rounds)
One other thing you should ask yourself once you need a valuation is when was the recent end of the accounting period? If the accounting period is closed, then you will be able to provide relatively accurate financials.
If your business closes its books on a monthly basis then there is no need to worry, you can just go with the most recent month to close the valuation date. If the books are closed quarterly, then the last closed quarter should be the valuation date. In case the books of the company are closed annually, then some accounting and finance resources need to be introduced as you will require more recent and better information about the company. You have the choice here of selecting the date when the period ends.
#3 When you issue stock options
Another question you need to ask yourself is when will you issue stock options. This is so because the normal catalyst of a 409a valuation is the company’s need to issue options. According to the IRS, stock options are considered to be deferred compensation. So they must be issued at the fair market value as such to avoid any issues with tax.
The valuation would be valid for 1 year from the 409a valuation date, so the price you get would be valid for the next 12 months for issuing stock options, except if any material events occur before then. A material event includes a major change in the prospectus of the company such as the financial structure, equity capital raise, and other major events.
How does a 409a Valuation save you from some IRS Penalties?
Early in the lifecycle of a company, financial analysis is run to define FMV. As with time, these valuations become more and more challenging and require more experience and time. There are many third party valuation providers such as Eqvista that would help save you from IRS penalties. In order to extract all the benefits of IRS safe harbor in the context of 409A valuations, it is essential that your company has completed an acceptable 409A valuation in the last 12 months.
In case you haven’t done it, consider doing it. If the IRS audits your company and decides that your valuation is grossly unreasonable, option-holders can be impacted. The employees who receive incorrectly priced options are either taxed on those options or they could be fined 20% of the value of option grants and have to pay penalties as well.
What triggers a 409A valuation?
A trigger is something that will raise the need for the company to get the 409a valuation done. There are many triggers in a company such as:
- Plans to issue stock options
- Setting a strike price for the shares
- Raising new funding round since the previous grant date
- Been more than 12 months since the last 409a valuation (FMV may have changed)
- The company is trying to value the regular shares of the company
How often is a 409A valuation required?
In an ideal situation, a company is expected to conduct a 409a valuation every year, or when there is a material event that has an impact on the value of the business. Any of which comes first.
A material event is an event in a company that has a significant impact such as new equity financings, instances of secondary sales of regular shares, merger or acquisition by another business, anything bad or good that affects the financial outlook of the business. Also, any company that credibly approaches an Initial Public Offering needs to conduct a 409a valuation frequently such as monthly or quarterly.
Example of a 409a valuation date
Let us take an example of Buzz Ltd. They are a business that is looking to issue stock options to their employees. To do so they are required to get a 409a valuation done to determine the price of the stock options. They are now considering the valuation date, keeping in mind all the factors that affect the selection of a valuation date such as the end of the accounting period. Buzz Ltd keeps their accounts in Quickbooks which are updated monthly.
They can choose the date depending on when they are willing to issue the stock and when the books are updated. Since a 409a valuation is valid for 12 months, the company can choose June 30th (end of Q2) as its valuation date or if its books are updated regularly, the end of July.
How should you select a 409A valuation firm?
Now that you want to conduct a 409A valuation, you must choose a provider who has expertise in valuing companies that look like yours. A valuation provider should have the proper credentials and expertise to conduct valuations to assure 409A safe harbor and extensive experience in your sector, industry, and stage.
It is recommended not to engage with a valuation provider whose clients are primarily companies that are slow-growing or have stagnant growth. Consider it analogous to choosing a tax provider to do your personal income taxes: Select an account according to your preference that is just not just certified as a CPA but can also assist someone like you with their extensive experience. Having such a firm will help you leverage their experience across those similar clients to assist you without triggering red flags.
Get Your Company 409a Valuation from Eqvista
Valuation of a company is a process that needs to be handed to trusted professionals. Eqvista is a company that is backed by professionals that will help you get a 409a valuation. Additionally, Eqvista provides you with tools that will help you throughout your business that adhere to all the regulations such as the cap table management, issuing of shares, and company formation.