Role of 409A valuations in startup fundraising success

In the highly competitive race for raising funds, you must cover all your bases. No detail is insignificant, especially not tax compliance. So, 409A valuations become just as important as from previous fundraising rounds.

409A valuations can play an even bigger role in ensuring fundraising success if your startup is built around a few key players critical to your success.

In this article, we will uncover what 409A valuations are, if they affect startup fundraising, and how they ensure fundraising success. Read on to know more!

Introduction to 409A Valuations for Private Companies

409A valuations are required when a private company issues stock-based compensation for tax reasons. It is difficult to know the value of a private company for the IRS since there is no public consensus about their stock price.

A private company does not publish financial and other key information through periodic reports. Also its stocks are not traded over the exchanges.

So, private companies, like startups, must comply with Section 409A of the Internal Revenue Code (IRC), i.e. if they want to compensate employees with stocks.

409A Valuation and startup fundraising

It is normal for startups to have a 409A valuation lower than their fundraising valuation. At the startup stage, there is a lot of room for growth. Investors and founders factor in this growth. However, no company’s growth is set in stone.

Under normal market conditions, when every material detail about a public company is known, its stock price does not include speculation. The stock prices are meant to be prices someone in the market would pay if they knew every material detail about a company.

So, there cannot be speculation in 409A valuations either. Hence,it is lower than startup fundraising valuations.

What is Section 409A of the IRC all about you might ask?

Section 409A of the IRC deals with non-qualified deferred compensations (NQDCs) which are simply compensation plans that do not qualify for the same tax treatment under other sections of the IRC.

Some examples of NQDCs are employee stock ownership plans (ESOPs), phantom stocks, supplemental executive retirement plans (SERPs), and voluntary deferral plans.

Does a 409A valuation affect your startup’s fundraising valuation?

A 409A valuation does not affect your startup fundraising valuation. Let us see how!

Startups believe that a valuation lower than their previous round will affect their fundraising capabilities. A lower valuation makes it difficult for investors to exit. In such a situation, many investors would start exerting pressure to pursue short-term goals that improve the marketability of a startup’s equity shares.

For instance, if a startup gets a valuation of Series B lower than its Series A, then the investors from Series A cannot make their exit without taking a loss. So, they may team up and exert more pressure through the board of directors to improve its brand visibility, sales figures, and profitability metrics.

At this stage, most startups would be off perfecting their product and building efficient distribution systems. Hence, the startup’s growth may be limited and it may ultimately fail to attract investor attention.

Investors themselves are wary of startups whose valuations have been falling. We have seen various startups like Theranos that inflated their capabilities and ultimately suffered brutal drops.

409A valuations are not connected to a startup’s fundraising valuations?

409A valuations are not connected to a startup’s fundraising valuations. They do not form the basis for startup fundraising valuations and it is wrongfully seen with a negative perception since they are typically lower. At their cores, both are very different.

In startup fundraising rounds, valuations are set after considering the growth potential, a very speculative factor because of the short financial history and untested products. Thus, there is a huge difference between both .

Fundraising valuations are a representation of the price paid by investors for equity in the company and others are meant to establish the purchase price offered in stock-based compensation like ESOPs.

How do 409A valuations ensure startup fundraising success?

409A valuations can help ensure startup fundraising success in the following manner:

Scrutinising hiring plans

• Necessity to top talent – Attracting top talent for key positions is essential but challenging for startups.
• Competitive disadvantage – Startups may not match the benefits and stability of established companies.
• Solution – Startups can offer employees the chance to take on significant responsibilities usually reserved for more experienced employees, which can accelerate their career growth. Additionally, startups can offer attractive equity-linked compensation that allows employees to share in the company’s growth.
• Investor perspective – Investors will want to ensure that the company is retaining talent without excessively diluting equity value. For this purpose, access to 409A valuation reports and cap tables is necessary as it allows them to verify the FMVs and assess the equity deals offered to employees.

Ensuring tax compliance

• IRS requirement – Startups must set the purchase price in equity-linked compensations as per the FMV of their shares. This FMV is established through a 409A valuation.
• Investor perspective – Investors may want to verify that the equity-linked compensations were issued in a tax-compliant manner. Some investors may ask their teams to check whether the methodologies and reporting principles were followed. Once investors have verified this, they will have confidence that you take tax compliance and regulatory issues with care.

Compensation strategies for higher-level positions

• Cash constraints – Startups need to reinvest revenue to fund growth, limiting their ability to offer high salaries or performance-linked bonuses.
• Solution – Startups can defer compensation by offering equity-linked compensation at a discount.
• Vesting period – Equity-linked compensation like ESOPs typically vest over 3 to 5 years to align the rewards with the employee’s contribution to the company’s growth.
• Investor perspective – Investors will want to understand if you are offering too much of a discount, i.e. over-compensating. They will also want to know if the vesting periods are so short that employees get benefits before earning them. For this purpose, investors will want to look at your 409A valuation reports as it helps them quantify the discount.

Attract the best talents with Eqvista’s 409A valuation

From a legal and compliance point-of-view, investors prefer a company that gets 409A valuations when it is urgent. This plays an important role in ensuring that the equity-linked compensations you offer are tax-compliant. Although the taxes on such compensations paid by the employees. Any negligence can still result in legal disputes.

Investors may ask for access to your 409A valuation history and cap table. This helps to verify the FMV and the deals being offered to key employees. This is important for a company whose growth depends on maintaining a talented team.

Eqvista’s 409A valuations offer accurate and affordable with extensive and detailed reports. This satisfies the curiosity of your potential investors and helps you stay tax-compliant. Contact us to know more!