When you have a startup or company, there are a lot of terms to learn, including 409a valuation. Discover what this is and what it is used for.
A 409A valuation is an appraisal of a private company's common stock's fair market value. It is conducted independently. The 409A valuation is essential to determine how much it costs to buy a share of the stock. As such, you need a 409A valuation to be able to offer equity.
Take a closer look at 409A valuations to get a better idea of how important they are for your small company and your investors.
Your Guide To 409A Valuations
In addition to understanding what a 409A valuation is, you need to consider other important things about them. This guide looks at the most important information for founders of companies or potential investors to know.
What Is A 409A Valuation?
The 409A valuation determines the fair market value of the common stock of a private company. As a refresher, common stock is the stock that is typically reserved for founders or employees.
The valuation process is part of the IRS's internal revenue code, and it is used to figure out how much a share of the company should cost.
Why Do 409A Valuations Exist?
409A valuations were created as a response to the Enron scandal in 2001. The IRC Section 409A was introduced by the IRS in 2005, and the final version has been in effect since 2009.
The goal is to prevent executives from using equity loopholes to their advantage. In Section 409A, you will find a framework that private companies have to follow when they value private stock. The valuation should be completed by an independent or unaffiliated party. When this happens, it creates a "safe harbor." As such, the IRS presumes that it is "reasonable," with very few exceptions. We'll discuss this in more detail below.
Importantly, if a company doesn't follow the rules in Section 409A when valuing its stock, the IRS can require them to pay penalties. In most cases, these are paid by the shareholders and employees.
What To Know About Safe Harbor Valuations
A 409A safe harbor has to be handled under even more specific rules. But you get the benefit of the IRS assuming it is valid unless it seems "grossly unreasonable." The IRS allows for three main methods of evaluating the fair market value and being considered a safe harbor. These are the independent appraisal, binding formula, or illiquid startup presumptions.
Of these, the independent appraisal assumption is the most common. This requires you to use a qualified third-party appraiser. Meeting that basic requirement means that the IRS would have to show your 409A valuation is "grossly unreasonable."
What Are The 409A Penalties If You Don't Get A Safe Harbor Valuation?
If you don't get a 409A safe harbor valuation, you could be facing significant penalties. These would affect shareholders and employees and can include:
- Accrued interest on any revised taxable amount
- Any deferred compensation becomes immediately taxable (from the current and previous years)
- An extra 20% tax on all the deferred compensation
Additionally, the penalties can be extremely bad for employee morale. This comes from the tax burdens that they will face if you aren't compliant. Tax penalties can easily be sizable if your valuation is incorrect, and your employees will have to pay their owed taxes out-of-pocket. This has an obvious negative effect on the reputation of your company and the productivity of your employees.
Will I Be Audited?
The good news is that while your company is a startup, the IRS isn't likely to audit it. But as it grows, the chance of an audit increases. This is also true when you are going to have an IPO, acquisition, or merger.
When Do You Need A 409A Valuation?
You will need a 409A valuation before you can offer equity or common stock options. Founders of any company in the early stage should also get 409A valuations, as this lets shareholders avoid IRS penalties on their taxes.
As a rule of thumb, you should get a 409A valuation in the following situations:
- Before issuing the first common stock options
- After a venture financing round
- Before a merger, acquisition, or IPO
- Every 12 months (or after any material event)
409As Are Required Before Offering Equity On A Tax-Free Basis
One of the most common of the above reasons to get a 409A is needing one before you can offer stock options to your employees on a tax-free basis. This is because part of Section 409A of the tax code requires companies to list the exercise price of stock options. As a refresher, the exercise price is the price that employees pay to purchase shares of the common stock after they vest.
The reason you need a 409A valuation for this is simple. The company won't have the stock listed on a public stock exchange, so the value isn't easy to find otherwise.
What Are Material Events?
For reference, a material event is anything that could potentially affect the price of the company's stock. In an early-stage startup, qualified financing will be the most common example. That refers to when preferred equity, convertible debt, or common shares are sold to institutional investors who pay a negotiated price.
Overall, some potential material events that can require you to have another 409A valuation include:
- Qualified financing
- Significant, lost, or new contract that is a material change in your revenue
- A potential acquirer giving your company a term sheet
- A material closed acquisition where your company is the buyer or seller
- A strategic partnership that will probably boost margins or open new markets
- Regulatory changes that significantly change your addressable market (increasing or decreasing it)
How Much Does A 409A Valuation Cost?
You can expect to pay anywhere from $1,000 to $10,000 for a 409A valuation, but it will be closer to $2,000 to $5,000 for most companies. It will depend on the size of your company and its complexity. It is worth noting that some companies offering 409A valuations also offer them in bundles with other services. In that case, the overall price will depend on the other services included.
Startup 409A Valuation – How Long Is A 409A Valuation Good For?
Part of the reason you should get a 409A valuation every 12 months is that this is how long it is good for. This is the maximum length of time for which an IRC 409A valuation is valid. Keep in mind that it may be valid for less time if there is a material event. These new 409As done after 12 months or a material event are called 409A refreshes.
How Is the 409A Valuation Completed?
Independent appraisers will typically use one of several common methods to determine the fair market value for your 409A.
This is the most common method when you need a 409A valuation for a financing round. This frequently relies on the option pricing model (OPM) backsolve valuation method. It can also use financial information from similar public companies to estimate the equity value of the company. Specifically, it will look at the stock price, earnings, and revenue before interest, depreciation, amortization, and taxes.
This approach is an option if a business has positive cash flow and enough revenue. It defines the value of the company based on the predicted future cash flow with adjustments for risk.
This is common if your company is in the early stages and doesn't yet generate revenue and hasn't raised money. It involves calculating the company's net asset value.
What Information Is Needed For The Valuation?
The exact information that you need for a 409A valuation will depend on the independent party completing it. But the following are common requirements:
- CEO's name
- External audit firm's name (if applicable)
- Legal counsel's name
- Articles of incorporation (amended and restated)
- List of comparable, relevant public companies
- Likely timing of liquidity events
- Company's business plan, executive summary, or presentation
- Historical financial statements
- Capitalization table
- Forecasted revenue for the next year (starting at the valuation date and going to the following two calendar years)
- Forecasted EBITDA for the next year (starting at the valuation date and going to the following two calendar years)
- Share purchase agreements (if applicable)
- Estimates of options to be issued in the next year (according to the hiring plan)
- Amount of nonconvertible debt
- Cash burn and runway
- Materially relevant events since the previous 409A valuation
What Happens After The Valuation
After the valuation, but before you issue stock options, your company's board will usually have to vote to approve the valuation.
A 409A valuation is used to figure out the fair market value of the common stock options offered by a company. You need to have it calculated before you can offer stock options to your employees. You also have to update it every year or after significant events. Always get a safe harbor 409A valuation, as there can be serious penalties if you don't.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.