A business valuation is a process of determining a company’s monetary value. A business valuation is used to determine the fair market value of a company, which is the price at which the company may be sold (if decided as so). The purposes of valuation include obtaining the sale value, determining employee compensation packages, and establishing partner ownership. A 409A valuation is necessary prior to issuing the first common stock options if you now provide equity or intend to do so in the future.
The 409A moniker is derived from IRS Section 409A, which concerns the taxation of deferred payments in the United States, including stock options and equity grants. A 409A valuation is an impartial third-party appraisal of a private company’s common shares’ fair market value (FMV). Typically, startups pay for these evaluations and then use the results to determine the price at which employees can purchase common stock. The portion of a company’s shares designated for employees and founders is known as common stock.
Origin of The 409A Valuation
Stock option grants were not regarded as taxable events in the United States prior to 2007. What changed then? In a single word: Enron. Now, in order for grants to be exempt from taxation, businesses must comply with Internal Revenue Code Section 409A.
In the years preceding the company’s 2001 bankruptcy, Enron executives committed a variety of wrongdoings. Those who were granted huge stock options awards expedited the vesting of their options and subsequently exercised and sold stock while the company’s shares were trading at all-time highs, fully aware that they were exaggerating the value of the business in order to increase the company’s valuation. As the deception came to light, it revealed flaws in non-retirement tax-deferred pay that Congress had largely overlooked up until that point. Existing insider trading laws did not encompass the Enron stock options fraud; therefore, as a reaction, Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004.
Section 409A excludes stock options from the U.S. definition of “tax-deferred remuneration” if certain conditions are not met. Companies can largely disregard Section 409A if they award employees stock options with a strike price (the price at which the stock can be purchased) exactly equal to the common stock’s fair market value (FMV) at the time of grant. This is simple for publicly traded corporations where the current stock price represents the fair market value. However, it is difficult for privately held enterprises, such as startups.
How Does A 409A Valuation Work?
To comprehend 409a valuations, it is necessary to comprehend how private corporations compensate employees with stock options. Here is an example of their operation:
Company A hires new workers and gives them the option to buy 1,000 shares of stock at the going rate. Let’s pretend that the value of a share is $1 right now. The word “strike” refers to this particular cost.
Company A informs the employee that he or she may “exercise” the option after five years of employment. This is known as the “vesting period.” The vesting time varies among companies.
The employee exercises their option to purchase 1,000 shares at $1 every five years after the shares’ value has increased to $30 a share.
The employee has the option to either retain the stock or sell it for $30 a share to generate a profit.
In this case, the option price being offered to employees must be determined using a 409a valuation. The IRS would rather a company not make up a valuation at all. While it’s true that employees would rather buy shares at a discount, your company could be accused of issuing artificially low stock options in order to conceal profits if its valuation is too low.
Why Do Startups Require A 409A Valuation?
Startups need 409A reporting because the IRS requires that options be priced at or above fair market value. Otherwise, issuing “cheap stock,” or options priced below fair market value, creates a taxable event for the employees receiving the options.
What Occurs If You Lack A 409A Valuation?
Not pricing stock options might raise serious tax issues with the Internal Revenue Service since it could be interpreted as a gift.
Owners of stock options who are in breach of Section 409A will be responsible for paying taxes, as well as a 20% federal penalty, any applicable state penalties, a tax underpayment penalty from the Internal Revenue Service (IRS), and any unpaid tax interest.
The IRS probably won’t audit most businesses for violations of 409A. The likelihood of an audit increasing, however, increases as your firm begins to generate revenue. Money and time will be needed for this.
In addition, the Securities and Exchange Commission, which scrutinizes pre-IPO stock awards, will certainly ask you difficult questions.
How Much Time Does The 409A Valuation Process Require?
According to Capshare, the following is a typical timeline when working with a valuation firm:
This includes your capitalization table, articles of incorporation, financial projections, term sheets, and previous 409A reports.
Run the report (10 to 20 days): If you want your valuation faster, anticipate paying $1,000 to $3,000 minimum.
Examine the first draft (15 min-1 hour).
Revisions (1-2 days) (1-2 days).
The final report will be presented (in 1-10 days).
Why Should Venture Capitalists Care About the 409A Valuation?
Due to two factors, the 409A valuation often has little impact on a corporation’s pre/post-money valuation.
Demand from investors is a major factor in how much capital a startup is able to obtain, and market forces often dictate how much a firm is worth.
Investors in venture capital obtain preferred stock, which carries specific rights and benefits not accorded to common stockholders and is, as a result, seen as more valuable.
Due to both of these factors, the per-share price paid by venture capitalists is frequently higher than what it would cost an employee to exercise their options.
On the other hand, pre/post-money valuations have an effect on 409A valuations. An appraiser will likely boost the 409A valuation of a company following major fundraising, which might indirectly harm investors by increasing the exercise price of an employee’s stock options.
Moreover, how a company approaches a 409A valuation can be instructive for VCs. If the founders fail to establish a safe harbor, it can create massive liability for the company and its employees. If the IRS comes down on the company, the tax penalties on employee options could cause a talent exodus.
In addition, poor 409A practices have the potential to derail an acquisition. If a company plans an IPO, regulators, bankers, and their legal counsel will review option issuances for irregularities. If the parties discover irregularities, it could reflect poorly on the company’s management and cause concern among potential investors.
Is It Better to Have a High or Low 409A Valuation?
409As are used to price options, which are used to reward early employees for their risk and bring new talent into the company. Typically, management wishes to grant as many shares as possible at the lowest possible price to encourage long-term wealth growth.
However, an established framework considers the startup’s growth stage and many other factors to assign a value. From this perspective, a valuation may be both a science and an art to capture the upside associated with a startup as well as the dangers inherent in growing a firm.
When Is A 409A Necessary?
You must obtain a 409A valuation:
- Before issuing your initial stock options
- After securing a round of venture capital
- Once each twelve months (or after a material event)
If you’re contemplating a public offering, merger, or acquisition, you should:
An IRC 409A valuation is only good for 12 months after its effective date or until a material event occurs that causes a change in the value of the company’s stock.
The selling of common stock, preferred stock, or convertible debt to external institutional investors at a predetermined price is the most typical material event for most startups.
What Distinguishes The 409A From Other Valuations?
Valuation is one of those omnipresent terms when discussing startups and stock market multiples. However, it can be perplexing because there is more than one form.
In fact, there are multiple types of valuations, and they come into play at different stages of a company’s lifecycle. For instance, private company valuation figures get bandied about, such as the numbers cited for Uber and Airbnb. There are also public market valuations for where stocks trade now and predictions for their future value.
Below, we will outline the fundamental differences between business valuations and startup values, as well as 409A valuations.
1. Business valuations = the price of the company.
They are calculated based on the following:
- Funds flow (current and projected)
- The monetary value of tangible and intangible assets.
- Existence of easily recognized prospective strategic purchasers
- Market sentiment
2. Startup valuations = what someone is willing to pay.
They are dependent on the following:
- The size of the opportunity as assessed by market expansion
- The team – its members’ domain competence, track record, reputation, and prior success stories
- Your capital requirements — how much you intend to spend, on what assets, and for what anticipated outcome.
- Option pool – size is the determining factor. The larger the pool, the lower your valuation.
- Preference for preferred stock participation
How popular a sector is at any particular time is often known as market sentiment. Comparables derived from recent fundings/exits.
3. 409A valuations equal the market price of a company’s ordinary stock (used for issuing stock options).
What impacts a company’s 409A valuation:
- Company landmarks
- The industry’s competitive environment
- Strategic alliances
- Your financier base
- The caliber of your administration
What Is A 409A Safe Harbor?
When your 409A is handled in a certain manner, it qualifies for “safe harbor” status. A safe harbor valuation is one the IRS presumes to be valid unless it can be shown to be “grossly unreasonable.”
A 409A valuation is presumed reasonable if the stock was valued within 12 months of the applicable option grant date and there was no material change between the valuation date and the grant date. If these conditions are met, the IRS bears the burden of proving that the valuation is “grossly unreasonable.”
Three Approaches to A “Safe Harbor” Valuation
Here are three safe harbor valuation methods:
Independent evaluation method
The valuation is assessed by a competent, independent appraiser during the last 12 months.
However, only a select few businesses will be able to take advantage of this strategy due to the stringent requirements. In particular, the stock must be subject to non-lapse restrictions (buy/sell agreements) that require the holder to sell the stock back to the company at the formula price, and b) the formula must be used continuously for compensatory and non-compensatory purposes for all transactions in which the issuer is either the buyer or seller of the common stock.
Illiquid startup method
For an illiquid startup (generally less than ten years in business with non-publicly traded securities) that is not anticipating a change of control in 90 days or a public offering in 180 days, a valuation can be considered safe harbor if it is completed by a “qualified” (but not necessarily independent) person who meets expertise/experience standards outlined by the IRS, is documented in a written report, and considers relevant valuation factor.
Employing an independent appraiser
With all the limits and requirements that must be met to qualify for safe harbor, it is crucial that firms have in place the right valuation and governance mechanisms to guarantee that stock options are issued with the correct strike prices.
Employing an independent appraiser to complete a 409A valuation is the simplest and safest approach to shield your employees from future IRS penalties and create a safe harbor.
How Do I Obtain A 409A Valuation?
Now that you understand when and why you need a 409A valuation report let’s explore how to obtain one. Three methods exist for acquiring a 409A value report:
Option 1: Do the 409a valuation yourself
If, after reading the preceding sections of this article, you still have the question “What if I conduct the valuation myself?” in your mind, continue reading to get the solution.
Assume you are not a professional appraiser, as you would not be reading about the 409A assessment if you were. Furthermore, no specific certification requirements exist to become a professional 409A valuer. To do a 409A valuation independently, however, the IRS states that you need to have extensive and appropriate knowledge, training, education, and experience in the area.
And if you have the skills and meet the IRS’s requirements, you can do it yourself and avoid any IRS valuation penalties.
On the other hand, doing it yourself would not qualify you for safe harbor protection, and if your firm is audited, you will bear the complete burden of evidence. Therefore, this alternative is not considered the best.
Option 2: Use a software tool
There may have been a time when you considered whether it would be preferable to pay for a program or use a free one to complete your 409A valuation. Doing so would eliminate the need to pay a third party to accomplish it.
The benefits of using the software include a reduction in the amount of time required to obtain the report and a reduction in the amount of money you would have spent on a professional evaluator. This would be of great assistance in the early phases.
On the other hand, you would not receive safe harbor protection, and if you are audited, the burden of evidence is on you. Furthermore, not everyone can use the program; you must meet the qualifications to utilize it correctly.
Option 3: Hire a firm
In the end, the best and most dependable choice is to employ a professional valuator or a company that can provide you with the 409A valuation and safe harbor protection. In doing so, you would not have the burden of proof when the IRS audits your business.
For this, however, you would need to find a firm that is both aware and experienced with the 409A valuation, and it should be able to provide you with the correct value so that you may avoid potential IRS valuation fines.
How Should I Choose A 409A Valuation Company?
A valuation firm should not only have the appropriate credentials and expertise doing valuations to assure 409A safe harbor but should also have considerable experience in your area, industry, and stage.
For instance, don’t engage a valuation provider whose clients are primarily Midwest-based, slow-growing, profitable brick-and-mortar businesses if you’re a high-growth yet unprofitable enterprise SaaS company headquartered in Silicon Valley (and yes, I have helped companies where this has happened!). Think of it as selecting a tax provider to do your personal income taxes: You would choose a tax accountant who is not only certified but also specializes in your particular tax situation.
You should also choose a valuation provider with strong relationships at major audit firms – the Big-4 accounting firms (Deloitte, PWC, KPMG, and E&Y) and/or large regional firms in your area – with the relevant sector heads/partners at that firm’s venture practice. This indicates that the valuation firm has demonstrated that its work is defensible and respected by audit community experts.
The 409A demonstrates growth in the company. Is the company in a better position than it was previously? The 409A will thereafter rise. And the growth is greater the faster the company grows. At the moment of issuance, companies should issue options depending on their real-time value. An employee can benefit from a low 409A valuation and strike price at the time of issuance if the company’s value continues to rise.