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When Do You Need a 409a Valuation? Process Overview for Startups

Posted by Early Growth

May 22, 2020    |     19-minute read (3771 words)

As an entrepreneur, valuation of your company is something that you’re always thinking about.  However, you may have heard something about a 409A valuation and are wondering…

  • What is a 409A valuation?
  • Why do startups need a fair market value analysis?
  • When do you need a 409A analysis?
  • How is a 409A valuation calculated?
  • Who can help provide 409A valuation services?
We’ll help you sort through all those questions and more. In addition to the basics of a 409A valuation, we’ll also address questions about if and how the current COVID-19 pandemic might affect whether you need to update your existing 409A valuation (spoiler: you might not need to, but it could be beneficial to update it now).    
What Is A 409A Valuation And Why Do Startups Need It?
The Internal Revenue Code Section 409A is meant to regulate how companies treat “nonqualified deferred compensation” that they give to their employees instead of a higher salary. A 409A valuation is usually performed to help new and existing companies set a reasonable strike price for any employee stock options they choose to issue. Those options have to meet Fair Market Value shares or come in above it. It’s best to have an objective and qualified third-party provide the valuation, which usually means hiring an appraisal firm. Section 409A puts forth the guidelines that must be considered before the issuance of both shares and options, laying out the regulatory requirements involved. It was enacted in response to rampant pricing manipulations that occurred throughout the 90’s and the first half of the last decade by Enron and other large entities who often abused the previous method of setting the valuation internally. 409A is mostly meant to ensure that the proper federal income taxes are paid on deferred compensation plans, but it also ensures that company options are covered by the IRS safe harbor. Not complying will result in the federal government taxing you and your employees for that stock and slapping you with hefty fines, usually a 20 percent tax, as well as interest payments. It will not only make your employees extremely unhappy (to say the least), but it can also put the acquisition of your company in jeopardy. After all, what buyer wants to deal with the tax risk and indemnities you’ve incurred for not following the tax code?  
When Is A Good Time To Get A 409A Valuation?
We understand that the last thing any startup wants to worry about is the taxes and legal side of running a business. It’s easy to let tax considerations slide when you have so many other things to worry about, like raising your new angel funding or venture capital. But every startup needs to think about tax law early in time to avoid confusion later. As with all things government-related, it’s complicated and can impact or change your company greatly.  
How Do You Know When You Need A 409A Valuation?
Let’s say, for example, that you want to hire top-notch talent with lots of experience, but you don’t quite have enough money to pay their current salaries. So, you offer them stock options and shares in the company instead—the nonqualified deferred compensation referred to in Section 409A. If a startup CFO wants to offer stock options or shares to employees, then the company needs a 409A valuation in order to comply with federal tax code regarding the strike price for those stock options. Usually, a startup CFO wants to put off their company’s valuation until after their Series A funding because many appraisal firms will charge around $5,000 for a 409A valuation, which is generally not worth it until the company has the funds to cover it easily. However, if your company is ready to create and grant good options to employees, then you’ll need an IRS 409A valuation to ensure that your option plans are covered by the IRS safe harbor. If you answer “yes” to any of the following questions, it’s time to contact Early Growth for a 409A valuation:
  • Are you trying to value the common stock of a company?
  • Do you plan to issue stock options and set your strike price?
  • Have you raised a new round of funding since your last grant date?
  • Are you looking to sell IP from one company to another?
  • Has it been 12 months since your last 409A? (Fair Market Value of your shares might have changed)
How Long Is It Good For?
The valuation term is valid for one year after the Valuation Date or until a material event impacts the value of the company. Any new rounds of funding or additional grants (equity or debt), major long-term contracts, change in business models, or increased regulation within the industry can impact the valuation of the company depending on the circumstances. The company’s position should be reviewed at each option grant, and this is something a valuation firm can help you to determine with a brief phone call.  
Do Events Like The COVID-19 Pandemic Require Me To Update My Valuation?
Our advice is “yes, if your value is going up, and no if your value is going down.” Remember, the 409A safe harbor is in place if the valuation you use for your stock options is equal to or greater than your 409A valuation.  Events such as the COVID-19 pandemic, which have caused all company valuations across the board, both public and private, to decrease have likely impacted your company valuation in the same way.  As a result, you’re probably OK from a tax risk standpoint if you continue to grant options at the same valuation, but you’re not doing right by your employees to grant them options that are overvalued. Although no startup wants their valuation to go down, when it does happen as a result of external events, updating your 409A valuation could present an opportunity.  Lowering the exercise price of your stock options to the new, lower fair market value ensures that new employees receive shares that are fairly priced.  No new hire wants to receive options that are “underwater.”   [bctt tweet="Events such as the COVID-19 pandemic have caused company valuations to decrease. Although no startup wants their valuation to go down, when it does happen, updating your 409A valuation could present an opportunity." username="earlygrowthfs"] You can also consider canceling existing employee options that are overpriced and “out of the money” and replace them with new options at the lower exercise price.  In challenging economic times when you might be cutting employees, reducing salaries, and eliminating bonuses, updating an employee’s stock option exercise price might help offset some of the impacts on your team.  One quick note, though, if you are considering canceling existing options… make sure to consult with your attorney and accountant as there could be tax implications of canceling options.  
What Comprises A 409A Valuation?
The 409a valuation process involves several dimensions of measurement to determine overall worth and value. Some of the starting data points will be the ratio of Tangible: Intangible company assets, the Net Present Value of Future Cash Flow, the Book Value of private and public comparative companies, as well as the Control Premiums and Discounts for Lack Of Marketability. Many other factors come into play as well, especially if mergers have taken place.  
How Is A 409A Valuation Calculated?
That’s probably too complicated a question to completely answer here as we could write another 5,000 words on that topic alone, but suffice it to say that company valuation is a bit science and a bit art.  We’ll do our best to provide a quick highlight of what’s going on behind the valuation. Grounded in economic concepts such as Net Present Value of Discounted Cash Flows, there are also elements of supply and demand in a company valuation.  You’ve heard the sayings “beauty is in the eye of the beholder” and “something is worth whatever someone else is willing to pay for it,” right?  Valuations of all sorts are highly subjective. When it comes to 409A valuations, there are numerous methods used to calculate the overall valuation of the company (which is called the Enterprise Value), and more importantly, the Common Stock of the company and options to purchase the Common Stock (which is what you grant to employees).  The three most common methods used to calculate the Enterprise Value are:
  • Asset Method - where the value is based on the value of the underlying assets
  • Income Method - where the value is based on the future discounted cash flows
  • Market Method - where the value is based on comparable valuations in the market
The Asset Method is typically used when determining the value of capital-intensive businesses or holding companies.  That doesn’t usually fit the profile of a startup, so that method is rarely used. The Income Method is probably the most objective method, but it is also one of the most difficult to calculate for an early-stage business.  Predicting future cash flows is almost impossible to do reliably with startups, given the significant risks and uncertainties.  As such, that method is also rarely used for 409A valuations for startups. That leaves us with the Market Method, which is the most common method used in 409A valuations. This method of valuation is related to the economic principles of competition that suggest that buyers will not pay more for a business, and sellers will not accept less, than the price of a comparable business.  This is similar to the “comparable sales” method that is used in real estate appraisals. [bctt tweet="Company valuation is a bit science & art. 409A valuations are complex enough that you can't do it yourself... an experienced CFO is a must." username="earlygrowthfs"] For a 409A valuation, comparables can include public company stock market valuations. However, it’s often difficult to find direct comparables as the size and maturity of public companies is so different from an early stage startup.  Private market comparables are possible, though gathering verifiable valuations of other private companies is usually equally difficult. In each case, the valuation comparable needs to consider whether the price reflects a non-controlling interest (such as buying a share of stock in a publicly-traded company) or whether it’s a controlling interest (such as the valuation when acquiring a company).   Because of difficulties in finding market comparables, the most common input to determine the valuation of a private company is a recent fundraising of that company… which is a fair market transaction of its securities.  Valuation experts call this the Backsolve Method. The Backsolve Method seems a bit like cheating, but a recent financing with a 3rd party is the best indicator of valuation. Since the valuation is often “backed into” as a result of a recent financing, and the recent financing was the driver behind updating your 409A valuation, you might be wondering what is so complex about this valuation stuff and why is an expert required? Well, for one, this input is only part of the valuation equation.  If the expert can utilize one of the other valuation methods, they will usually provide a valuation that is a weighted average of the various methods. Another reason is that there are several other inputs to a valuation as the business and the environment is continually changing.  Lastly, the Enterprise Value is just the starting point of a 409A valuation. Usually, the end goal of a 409A valuation is to value a specific security of the company--the Common Stock and an option to buy Common Stock.  If you have several classes of stock, such as Preferred Series Seed or Preferred Series A, valuations of the Common Stock will need to consider the preferences that those other classes of shareholders have.  This will typically involve what’s called a waterfall analysis--an analysis of how each class of preferred shareholders will either elect to exercise their preferences or convert their preferred shares to common stock based on different valuations.  So, if your investors bought preferred shares at $5 per share, it’s likely that the Common Stock is valued at less than that. Finally, the last part of the 409A valuation puzzle is to value an option to purchase a share of Common Stock.  That’s not the same thing as the value of a share of common stock because the underlying option has value.  In order to calculate the value of the option, experts use something called the Black-Scholes model.  The formula is complex and includes inputs related to the volatility of the underlying security and lack of marketability.  Volatility is usually determined through the volatility of publicly traded comparable companies.  Lack of marketability, also called a “private market discount,” is subjective, but driven by reams of SEC guidance. Put all those things together, mix them up, add a touch of salt, bake for a few days, and you have a 409A valuation startup companies can use to set the exercise price for your common stock options. These concepts are complex enough that you can’t do-it-yourself, and you shouldn’t go it alone--an experienced CFO is a must.  
How 409A Differs From Other Valuations
Valuation is one of those ubiquitous words: at least when it comes to discussions around startups — and, of course, stock market multiples. But it can be confusing because there is not just one type. In fact, there are several types of valuations, and they come into play at different times in a company’s lifecycle. For example, there are the private company valuation figures that get bandied about: think the numbers people reference for Uber and Airbnb, for example. And there are public market valuations for where stocks trade now and predictions for what they’ll be worth in the future. And then there are 409A valuations. Below we'll walk through the key differences between business valuations and startup valuations. 1. Business valuations = the price of the company. They are calculated based on:
  • Cash flows (current and projected)
  • The value of physical and intangible assets
  • The existence of readily identifiable potential strategic buyers
  • Market sentiment
2. Startup valuations = what someone is willing to pay. They are dependent on:
  • The size of the opportunity — as measured by the market growth rate
  • The team — members’ domain expertise, track record, reputation, and history of prior success
  • Traction — this might be measured in users, revenues, downloads, or by some other yardstick
  • Your capital needs — how much you plan to spend, on what assets, for what expected impact
  • Option pool — the key determinant here is size. The larger the option pool, the lower your valuation
  • Preferred stock participation preference
  • How hot the space is at any given moment, aka market sentiment
  • Comparables based on recent financings/exits
3. 409A valuations = the value of the business’ Common Stock (utilized for issuing stock options). What impacts a company’s 409A valuation:
  • Company milestones
  • IP
  • The industry’s competitive dynamics
  • Strategic partnerships
  • Your investor base
  • The quality of your management team
Do you see the overlap with the factors that come into play for equity valuations?  
Getting Your 409A Valuation Report Started
If you’re ready for your 409A valuation, then you want to get a qualified third-party with experience to perform the valuation in order to determine that the Fair Market Value is accurate and reasonably calculated. There are plenty of good appraisal firms you can hire for the job, and normally a startup CFO would handle or change the details. Once you start granting options, you’ll need to update your valuation report at least every 12 months, if not more often, depending upon the growth of your company. Of course, if you aren’t at the point where you can hire a CFO, Early Growth offers startup consulting to help you manage things like 409A valuations, as well as accounting services and CFO services. Dealing with the federal tax code can be daunting, of course, but you don’t need to face it alone. Beyond being a required compliance document, it has the basis to affect each one of your employees who have stock options. While it can be generated by automated software, preparation by an independent appraiser or appraisal firm is the only way to guarantee safe harbor in the event of an audit. The recommended guidelines for choosing an appraiser or firm is a comprehensive background of at least five years in:
  •         Business Valuation
  •         Investment Banking
  •         Private Equity
  •         Or Other Similar Experience
This diverse and specialized background is especially necessary for corporations that are in the early stages, such as the first few years, and whose stock is highly illiquid. Being able to define it accurately and defend the methods and numbers used to create that assessed value is crucial to any rapidly growing firm issuing common stock to avoid the potential disaster of tax implications and severe penalties for both the business and the awardees of any common stock.  
7 Things To Look For In A Valuation Company
To find the best valuation company—and get your best valuation—here’s what you should be looking for: 1. Early-stage startup experience. There are many different types of valuation, including four levels of 409A : Seed, Series A, Series B, and Series C. You want a valuation firm that has experience with all types of 409a startup valuation for companies like yours, including stock option management and complex capitalization tables. Even if you’re only looking for a particular valuation type right now, further down the road, you’ll need a new valuation, and it’s nice to have an established relationship with a valuation firm that can manage it all—and offer discounts on future valuations. 2. Guarantee. Any reliable valuation company should put its money where its mouth is and guarantee to satisfy your audit. There should be some sort of guarantee about the accuracy of their market value analysis and its ability to withstand scrutiny. 3. AICPA-compliant valuation reports. If you get acquired, the acquiring company will request an audit—they will be looking closely at your 409A valuation. If the valuation firm made certain assumptions or didn’t address certain things in certain ways, this could slow down the acquisition and/or have a negative economic result. A valuation firm that advertises AICPA-compliant valuations that endure Big 4 and acquirer scrutiny demonstrates that they have the necessary rigor you need to make it through an acquisition as smoothly as possible. 4. Variety of approaches. From income approaches to market approaches to cost approaches (and don’t forget custom methods!), you want a valuation company that knows all the tools of the trade and will use the best combination of business valuation methods to get you your best 409a floor value startup valuation. 5. Fast. Whether you’re on your way to an acquisition or on the hunt for talent and need to make a quick offer, when you need your valuation, you need it. Valuation companies should be able to promise a quick turnaround—within seven days—and fast, free revisions, as necessary. 6. Availability. It makes sense to have an actual relationship with your valuation firm. They need to make themselves available to you and be open to necessary dialogue about valuation inputs, assumptions, special circumstances, etc. 7. Integrated approach. While some entrepreneurs choose to use a stand-alone valuation service, it makes more sense to have a more integrated approach to your financial needs, of which valuation is just one puzzle piece. If there is a seamless integration between your financial management and your valuation, that promises a faster, smoother valuation process. To support your valuation, you’ll need to supply relevant financial documents such as GAAP compliant financial statements, capitalization tables, balance sheets, profit and loss statements (P&L), and tax returns. If you have a firm already managing these finances, it makes sense to use them to handle your valuations as well. Valuation is one of those non,-mission critical, yet essential things that every startup needs to have. As with all non-mission-critical functions, it’s something that needs to be taken off your hands by someone you can trust who will deliver quality results. The right valuation company will understand your business and guarantee that you get a price that’s appropriate.  
Early Growth vs. Low Cost Valuations
Cap table software companies who perform the 409A valuation in-house, rather than outsourcing to an independent third-party firm, do not provide safe harbor due to independence. For an independent valuation firm to maintain its “independence”, they cannot provide you with any other services in addition to their valuation work. This is why Early Growth partners with Economics Partners to provide 409A valuation services.
“I caution on low-cost valuations. I know we are not going to be the cheapest out there, but we produce a very high-quality 409A that is highly defensible in an audit. A low-quality (low cost) 409A is much more likely to fail an audit, which could result in you having to re-price options, grant make-up options, and even compensate employees for having to re-issue them new options at higher strike prices. This can be very costly in terms of both money and time. At a low cost, they cannot put in the same time and resources to produce a quality audit-proof product.” – Brian Young, CFO, Early Growth.
We at Early Growth produce high-quality 409A reports that are highly defensible in an audit. Other low cost, no frills 409A service firms are much more likely to fail an audit, which could result in you having to re-price options, grant make-up options, and even compensate employees for having to re-issue them new options at higher strike prices. These events, when they occur, can be very costly in terms of both the financial impact as well as the loss of time. Low cost service firms cannot put in the same quality of time and resources to produce a quality audit defensible product on a par with ours. Contact Early Growth to find out more about our 409A valuation services.    

About Early Growth: Early Growth is the largest national provider of outsourced CFO & accounting services in the venture capital space. For over 10 years, Early Growth has been providing finance & accounting, tax, equity management, and fund accounting services to startups at all stages. Early Growth is a strategic partner handling your finances so you can focus on your business, customers, and team.

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