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White Paper: An In Depth Look at 409a Valuations

Posted by Early Growth

June 20, 2017    |     5-minute read (968 words)

There are many hats to be worn by the modern entrepreneur. It takes a certain focused type to deftly handle the juggling through of the myriad details involved in running a startup. Founders often excel at blending trends, experience and imagination, putting passion into a purpose.

Keeping an eye on creating new products, services or in some cases brand new markets it’s easy to overlook the finer specifics of financial management that are a necessity for the forward-thinking entrepreneur. After all, even the savviest of founders are not particularly well versed in the intricacies of corporate tax law.

One of those essential details that can make or break things for a swiftly growing firm is how well prepared, maintained and current your 409A valuation is.

What Is The 409a Valuation?

A 409A valuation is named for section 409A of the Internal Revenue Code of the IRS. 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.

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.

When Do You Need A 409a Valuation?

There are several scenarios where it is essential to have a 409A valuation generated, whether for the first time or as an update to a previous one. Valuations are valid for a period of one year, that is if all things remain constant, many companies perform them more frequently to maintain the best current valuation.

At the outset once your company is moving towards offering options on shares one should be generated. Other considerations for getting a 409A valuation are if new funding is being sought or if any secondary sales of company shares is taking place.

What Comprises A 409a Valuation?

The process involves several dimensions of measurement to determine overall worth and value. Some of the starting 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. There are many other factors that come into play as well, especially if mergers have taken place. In that event liquidation preferences will be an element.

How 409a Differs from Other Valuations

409A Valuations are valid for up to twelve months, this is if no significant material events have occurred within that window to alter or impact the worth of the firm. Many firms update their valuation throughout the year as well. In the event of any new rounds of funding being achieved a new 409A is needed. This is the case whether finances have been altered through either issuing equity or through debt instruments.

Several other scenarios necessitate updating your 409A valuation. Any substantial new business contracts, especially long term ones, will likely influence the company’s worth and an updated 409A should be completed to factor it in. Similarly, an overhaul of the existing business model necessitates one as does changes in the regulatory environment of the industry. Any of these particular circumstances can have varying degrees of impact on the 409A.

What Are the Penalties For An Improper Valuation?

An improperly calculated 409A can lead to two main penalties. One possibility is that there will be an immediate tax upon vesting if the exercise price is deemed to be below fair market value, as opposed to it being at the time of exercise or sale. The other possibility is for additional federal tax penalties of 20% over the regularly applicable state and federal taxes can be incurred. Other negative consequences can be state specific equivalent penalty taxes too.

We at Early Growth Financial Services 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.

About Early Growth

For over 10 years, Early Growth has provided early-stage companies CFO Consulting ServicesAccounting for Startups, Taxes, and 409a Valuation. We saw a need in the marketplace for a service that would allow founders to still focus on business while building a healthy financial story. Our Outsourced CFO, Outsourced Accounting, and R&D Credits services have helped many companies grow.

Learn how we can put more time back in your day.