Startup founders may pay employees fairly and meaningfully by utilizing equity-based compensation, often known as deferred compensation, without spending critical capital.
Deferred compensation is governed by Internal Revenue Code 409A, which mandates that you must get a valuation if you plan to distribute firm equity over time. Internal revenue code IRC 409A explains the steps you must take to determine the FMV (Fair Market Value) of your common stock.
If you intend to grant options to your employees, your startup needs a 409A valuation. But, how do startups value common shares when they give stock options, which are crucial for luring talent? The only way to offer tax-free options in a privately held corporation is through a 409a valuation. The cost of this valuation is often covered by startups, who use the results to determine the strike price, also known as the exercise price. Later on, the exercise price will determine the appreciation of the employee options in an exit event.
There are multiple reasons why a company just starting would do this. It’s a great way to attract loyal employees! Employees who own a piece of the company feel more genuinely involved in their job. If a startup can’t afford to pay more significant compensation, stock options might be an excellent alternative.
To explain it in simplest terms, if you’re a startup looking to save its capital by offering equity, you’ll need a 409A valuation. What is it, and is it that beneficial? Keep reading to learn about the ABCs of 409A valuation.
What Is A 409A Valuation?
In the US, the Internal Revenue Service (IRS) defines a 409A valuation as “a written report prepared by an independent appraiser that sets forth the value of common stock of a privately held corporation.” This type of appraisal aims to establish the value of equity for tax purposes. It’s essential to have a 409A valuation done by an unbiased, third-party appraiser to avoid any potential conflict of interest.
Who Needs A 409A Valuation?
409A valuations are often required by investors, lenders, and potential acquirers. If you’re seeking venture capital funding, your investors will likely require a 409A valuation before they invest. The same applies if you want to take out a loan or sell your company. In these cases, a 409A valuation can help establish the value of your business and give you a better idea of how much equity you should be offering.
How To Perform A 409A Valuation- Common Methodologies
Financial professionals like mergers and acquisitions (M&A) specialists, equity research analysts, and venture capital (VC) companies use different methods to ensure your 409A valuation is ‘fair.’ It helps to determine the correct enterprise value. Although there are many ways to perform a 409A valuation, the most common ones are these three methods that you’ll see analysts using, i.e., market-based, income-based, and asset-based.
These three techniques are helpful for initial 409A valuations, but as a firm develops and changes its emphasis, the valuation provider may choose to utilize a different method. For instance, firms in their early stages rely on a market strategy, but a late-stage company operating for longer is more likely to adopt an income plan.
This valuation methodology is appropriate for underperforming, early-stage businesses where it is challenging to forecast future financial results.
How This Approach Works: The market technique is a relative valuation method. This means that the valuation provider compares your company to a group of similar publicly-traded businesses, usually in the same industry. We call these businesses “trading comps.”
After calculating the firm’s enterprise value and right valuation multiple using the fair market approach, a valuation provider may evaluate the right value of your company. In the IPO scenario, all the preferred stock converts to common, eliminating liquidation benefits.
This is usually an EBITDA multiple for businesses that are making money. But revenue multiples are used for businesses in their early stages when EBITDA is often negative. This method is called the “public company method” or “guideline public company method.”
Advantages & Disadvantages: The most significant benefit of the market-based approach is that it makes it simple to determine the multiples for publicly traded companies. But, due to the company’s imperfect fit into one or more categories, the comp set is frequently not representative. Since many early-stage companies are seeking to establish new markets or sectors, their comps will inevitably be inaccurate because no one else is doing what they do.
Adjustments are also made to try to account for the fact that the comparison isn’t perfect because the company is growing at a very different rate than its publicly traded counterparts (ideally much, much faster) and is a very different size.
For businesses with sufficient revenue and a positive cash flow, valuation experts prefer to employ the income technique. This method takes the total worth of the company’s assets and subtracts the associated tax liabilities to get the business’s fair market value.
How This Approach Works: The idea behind the income-based method is that the valuation provider will determine the value of a company based on how much money it makes in the future. The company’s long-term financial forecasts, which are then discounted back to their present value, are used to figure out these income levels. People often call this method the “Discounted Cash Flow” (DCF) method.
Advantages & Disadvantages: The advantage of this methodology is that the company’s anticipated future earnings directly impact it. In contrast, the drawback is that it needs accurate, validated long-term projections.
The income strategy also has the drawback of needing much auditing. The reason is that it makes arbitrary assumptions about things such as revenue growth, gross margins, customer loss, and operational costs, all of which are harder to predict as you get further into the cash flow term’s ten-year prediction.
When valuing businesses that don’t produce income and haven’t yet obtained capital, valuation firms frequently utilize the asset technique. The asset technique uses the net asset value to determine the appropriate valuation. Also, people who do valuations have to think about certain economic rights, such as conversion ratios, participation rights, and liquidation preferences.
How This Approach Works: This method uses replacement cost to determine how much a business is worth. Using this method, the firm can calculate its enterprise value by adding up the value of all of its assets and debts.
Advantages & Disadvantages: The benefit of the asset strategy is that there is no need for forecasting because the company’s growth potential is not considered. The problem with the asset-based method is that it doesn’t work for new businesses because it might be too expensive to evaluate some assets and liabilities, especially intangible ones like intellectual property.
How Is A 409A Valuation Different From Other Types Of Valuations?
Other types of business valuations include:
- Investment banking firm valuations
- Pre-money and post-money valuations
- Comparable company analysis (public market comparables)
- Option-pricing models
Each valuation method has a different application and should not be confused with a 409A valuation. For example, an investment banking firm valuation is used when a company goes public or is acquired, while a pre-money valuation is performed to establish the value of a business before it receives funding. Comparable company analysis is suitable for evaluating public companies, but it’s not an accurate method for valuing a private company. The same goes for option-pricing models, which are designed to value options and can’t be used to appraise equity.
What Is The 409A Valuation Process?
The 409A valuation process typically consists of four steps:
- Data gathering: The appraiser will collect financial and operational data about the company.
- Industry analysis: The appraiser will research the company’s industry, competitors, and market trends.
- Financial analysis: The appraiser will analyze the company’s financial statements and valuation models.
- Appraisal report: The appraiser will prepare a written report that includes the appraised value of the company’s common stock.
What Is A Fair Market Value (FMV) And How To Determine The FMV Of The Common Stock?
When estimating the worth of a public company’s stock, you may immediately check the open market share price online. However, with private businesses, such is not feasible. Before issuing securities, privately held companies must determine the fair market value (FMV) of their common shares using a 409A valuation.
The fair market value (FMV) is the price an asset would sell for on the open market if certain requirements are met.
The requirements are: The parties must know all the facts, act in their own best interests, not feel pressured to buy or sell, and have plenty of time to make a decision.
What Information Do You Need To Perform A 409A Valuation?
Now that you have a good understanding of what a 409A valuation is, now comes the part where you need to know what information and documents you’ll need. Firstly you’ll need information about your business and your industry. You also need to provide the timing of possible liquidity events, your financial statements, and any relevant events that have happened since your last 409A assessment.
Here’s a checklist of the information you’ll need to obtain a 409A valuation:
- Company details, including up-to-date Articles of Incorporation and bylaws. Your business profile must include senior executive bios. The best option is to put them in writing or link to your website’s management team page.
- Your appraiser will also want to know about your business’s history, type of industry, sources of income, competitors, market trends, etc. These things could determine and affect the value of your company.
- You’ll need to provide the appraiser with all previous IRC Section 409A values if you’ve had any.
- Include a copy of your capitalization table, trial balance report, and balance sheet of the company’s tangible and intangible assets as of the valuation date.
- A company being appraised must provide a year-end profit and loss statement.
If your company has been around for more than a year, you’ll need to obtain extra paperwork:
- You will need a rolling average of income, financial statements, and cash flow statements for the previous five years (or from the day of its inception).
Additionally, a private company with outstanding debt or convertible debt will need to provide furnish copies of the agreements for the repayment of debt.
How Often Do You Need To Conduct A 409A Valuation?
Three conditions trigger 409A valuations for corporations issuing stock options:
- Prior to issuing the company’s first round of stock options for its employees
- Each year- as each 409A valuation is valid for only 12 months.
- If your firm raises fresh funds.
If your company encounters a material event affecting its worth, you’ll need to conduct a 409A valuation.
What Constitutes a Material Event?
- The newest equity financings
- A purchase bid from a different firm
- Several instances of subsequent stock sales of common stock
- A substantial shift in the financial condition of your organization (positive or negative changes)
What Are The Risks Of A 409A Valuation?
If you don’t use an IRS-approved valuation methodology, you might be in violation of the 409A safe harbor. Employees and stockholders may be subject to significant fines:
- The current and previous years’ deferred pay is all immediately taxable.
- Amortization of the recalculated tax amount
- Compensation that is deferred will be subject to a 20% tax.
In the early stages of your business, IRS audits are unlikely. This, however, may arise in the future. Having a professional and independent third-party valuation firm on your side is a great investment because you won’t have to deal with the IRS or do the work yourself.
The Cost Of A 409A Valuation
Depending on your company’s size and complexity, a typical 409A appraisal might cost anywhere from $1,000 to over $5,000. For startups and Series A companies, this amounts to $1,000 to $3,000, and for larger organizations with numerous rounds of investment, this amounts to $3,000 to $5,000.
Major vital factors that determine a cost of 409a valuation:
- Stage of the corporation (Seed, Series A, Series B, Series C)
- The complexity of Shareholder Agreements
- The size of the business (total amount of assets, revenue per year)
- The Corporate Sector
- The Age of the Corporation
While a 409A valuation might not be among the top 10 exciting things for startup founders to do but it is among the top 10 necessary things.
There’s no way to grant stock options in your firm if you don’t know the company’s value as a whole. Accordingly, the first step for every firm that plans to begin offering stock options to its employees is a 409a valuation.
The best way to evaluate is via an independent third-party valuation firm. Your 409A valuation will determine your company’s common stock’s fair market value. Work collaboratively with your 409A plan provider to get an accurate value, and try to avoid questionable valuation processes and/or assumptions.