Securing Safe Harbor Status for Fintech Startups
For centuries, safe harbors have given sailors respite from the most unforgiving seas. Today, the concept of safe harbors extends far beyond the seven seas. In the stock market, safe harbor assets help investors take shelter from market volatility. Similarly, in the winding and treacherous landscape of tax regulations, safe harbors offer certainty and stability.
If you have issued stock-based compensation, you may have heard of Section 409a’s safe harbor provisions. In this article, we will explore how fintech startups can qualify for these safe harbor provisions and issue stock-based compensation with peace of mind.

What is the safe harbor status in 409A valuations?
Safe harbor provisions are available for various things including the tax on equity-linked compensations. As an American private company issuing equity-linked compensation such as ESOP, you can land in huge trouble if you fail to comply with Section 409A of IRC. Your employees will face hefty fines and penalties, and they may accuse you of negligence in lawsuits.
However, you can avoid such troubles if you attain a safe harbor status. This requires you to get a 409A valuation through one of the three prescribed methods.
How does safe harbor valuation benefit fintech companies?
Safe harbor methods, for fintech startups, are quite important since liquidity is especially important to them. Any fintech involved in segments like buy-now-pay-later, digital payments, banking, and lending will know the importance of maintaining a healthy stockpile of cash in case depositors want to make withdrawals.
Just the doubt that such a company may not pay back the deposits in the future can cause them to shut shop for good. Such sentiment among depositors will trigger a string of withdrawals that cannot be serviced. This is called a bank run and it has been the cause of death for many banks- most recently, the Silicon Valley Bank.
Equity-linked compensations like ESOPs can be a great way to conserve cash, only if startups can stay tax compliant that is. Hence safe harbor provisions, for these companies, are especially important.
Challenges in valuing fintech startups
Some of the issues fintech startups may face in getting accurate valuations are as follows:
Uncertain future cash flows
It is very difficult to estimate the cash flows of a fintech company, especially if it is involved in investing. The number of active users of an investing-related website will depend largely on the performance of the financial assets it provides access to. Even these startups that function as lenders will be affected by ongoing interest rates and economic conditions like inflation. This makes it very difficult to estimate future cash flows.
Regulatory uncertainty
Fintech companies are quite innovative and often break new ground. An advantage of this is companies can exploit untapped markets and a disadvantage is that they do not know how they will be regulated.
Take Stripe for example. It is a leading payment processing company that faced regulatory challenges in its global expansion. It had to build a protocol that aligned with the regulatory environments of various countries. However, the company had to pull out of India due to strict know-your-customer (KYC) norms.
Rapid technological changes
Fintech is a highly competitive space where we see new companies with novel technologies almost every year. It is the nature of new technology to replace whatever came before it and to be replaced by whatever comes after it. Fintech startups that cannot adopt new technologies in time may face huge losses and it may even cost them their survival.
Scalability concerns
Fintech is a space where scalability depends more on gaining the trust of users than on the quality of the product. Using a fintech product can significantly impact a user’s financial condition. So, a careful plan of their expansions into larger markets to ensure that their quality of service does not drop at any point.
This can be a tightrope too treacherous to walk on for many fintech startups.
Dependence on partnerships
Many fintech startups rely on partnerships with traditional financial institutions and banks to gain access to markets. These startups can leverage the reputation of their partners and also gain an effective distribution mode for their products. Whether such partnerships last or not can significantly impact the value of fintech startups.
Safe harbor provisions for fintech startups
A 409A valuation will be eligible for safe harbor provisions if it is less than 12 months old, no material events have occurred since the valuation, and one of the following valuation methods was used:
Illiquid startup presumption
If your company is less than 10 years old and you are not expecting a liquidity event like an initial public offering, fundraising round, or mergers and acquisitions (M&A) in the next 12 months, you can qualify for safe harbor provisions through the illiquid startup presumption.
Very basically, this method involves estimating your startup’s value by referring to recent equity transactions of similar companies and then applying a discount for your startup’s lack of liquidity.
Qualifying for safe harbor provisions is difficult through this method. The person performing the valuation must be an insider with proven expertise in valuations and they must record their valuation process in written form.
Binding formula presumption
Another way to qualify for safe harbor provisions is to have a consistent formula for all equity transactions. You can only use this presumption if the same valuation formula is used in every binding agreement to buy or sell your company’s equity, even in third-party transactions.
This method puts considerable limitations on a startup’s equity management operations.
Independent appraisal presumption
The independent appraisal presumption is the most widely used method to come under the protection of safe harbor provisions. Here, all a startup needs to do is find an appraiser with no stake in their company and a proven record for accurate valuations. For a small fee, the independent appraiser will help you get the protection of safe harbor provisions of the Section 409A. For instance, Eqvista offers unlimited 409A valuations starting from $990 for a year.
Example of fintech safe harbor valuation
In this example, we will show how Eqvista, an independent appraiser, performs a 409A valuation for Fintech Co so that it can get protection from safe harbor provisions. We know the following details about Fintech Co.
- Industry: Financial Technology
- Stage: Early stage
- Employees: 50
- Key Products: Mobile payment app, merchant payment gateway
From our discussion so far, you must have noticed the difficulty in accurately assessing future cash flows. Also, since this company has a small size, it will not have a lot of assets. So, we will assign more weight to the valuation from the market approach than from income and asset-based approaches.
Income approach
For the income approach, we will make the following assumptions:
- Net cash flows are expected to grow 50% every year until 2028
- Net cash flow of last year was $10 million
- Discounting rate is 15%
Year | Projected net cash flows (in millions) | Net present value |
---|---|---|
2024 | $15 | $13.04 |
2025 | $22.50 | $17.01 |
2026 | $33.75 | $22.19 |
2027 | $50.63 | $28.95 |
2028 | $75.94 | $37.75 |
Total | $118.95 | |
Valuation | $118.95 |
Market approach
To find the valuation through the market approach, we simply need to find the market valuation multiple for sales and apply it to Fintech Co’s sales of 2023.
Recent equity transactions for similar companies
Company | Sales (2023, in millions) | Valuation (in millions) |
---|---|---|
Nexus Finance | $10 | $100 |
Quantum Cash | $20 | $220 |
Cipher Wealth | $8 | $76 |
Flux Capital | $6 | $54 |
Synergy Pay | $30 | $340 |
Total | $74 | $790 |
Market sales valuation multiple = Total market valuation
Market sales: $790 million / $74 million = 10.68
Fintech Co’s sales for 2023 were $14 million.
So, the valuation of Fintech Co should be = 10.68 × $14 million
= $149.52 million
Asset-based approach
The value of Fintech Co’s net assets is $16 million.
Final valuation
Now, all we need to do is assign weights to each approach and find the weighted average which will be the final valuation.
Approach | Weight | Valuation (in millions) | Weighted value (in millions) |
---|---|---|---|
Income | 25% | $118.95 | $29.74 |
Market | 60% | $149.52 | $89.71 |
Asset-based | 15% | $16.00 | $2.40 |
Final valuation of Fintech Co (Total) | $121.85 |
Since this valuation was conducted by Eqvista, a qualified independent appraiser, as per the regulations of the Internal Revenue Service (IRS), it will help Fintech Co get protection under the safe harbor provisions of Section 409A.
Precise 409A valuations for fintech by Eqvista!
In this article, we explored the safe harbor provisions for fintech startups issuing equity-linked compensation under Section 409A. Cash-conscious fintech startups can benefit from equity-linked compensations as long as they get the protection of safe harbor provisions. By now you must understand the challenges and benefits of getting a reliable 409A valuation as a fintech company.
Ready to secure your compliance without breaking the bank? Eqvista offers expert, independent appraisals starting at just $990 per year. Contact us to know more!