When you are looking to sell your business, one of the most important factors that potential buyers will look at is the 409a valuation. This number determines the positive cash flow of your own company’s stock price and is a crucial indicator of a company’s worth. A reasonable 409a valuation can make or break a sale, so it’s important to know what goes into this calculation.
The purpose of a 409A valuation, which is an independent valuation of the private company’s common stock by a third party, determines the price for employee stock options.
The 409A valuation is a framework that privately held companies can use when granting private stock options to employees. With this valuation, equity-based awards need to be issued at or above FMV at the grant date.
That 409A valuation sets the tax basis for non-qualified stock options. If the company does well over time, then those shares will gain value. The employee’s taxes will be based on the difference in value from when the shares were granted to the time they received them or sold them.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
The fair market value of common stock in a private company is called a 409A valuation. This is determined by a third-party appraiser who offers 409A valuation services.
To grant employee stock options on a tax-free basis, startups need to obtain 409A valuations.
The 409A valuation determines the base price of a company’s common stocks, which is used to calculate the price at which employees may exercise their underlying stock options.
There is a critical difference between valuations in a 409A round and valuations in a funding round. 409A valuations don’t take into account market value demand.
Two types of valuations apply to startups: the pre-money (or post-money) company’s valuation is the value investors attach to the company as part of a financing round. The founder will also need the 409A valuation of an independent third party when granting stock options to employees in early stage companies.
Each time the company needs fundraising, its pre/post-money value is discussed between investors and founders. The 409A valuation is based on an independent appraiser to determine the company’s fair market value.
The pre/post-money and 409A affect each other in ways that is important for the VCs to understand. This guide will help provide the information investors need about 409A valuations. Also explained are why they are necessary, how they are determined, and the similarities and differences between pre/post-money and 409A valuations.
A 409A valuation performed by an independent third party, assesses the fair market value (FMV). Startups usually pay for these assessments. The findings then inform the price at which employees can buy shares of private company’s common stock. Common stock refers to the stock that is reserved for founders and employees.
To offer equity to employees on a tax-free basis, private companies must have 409A valuations.
Section 409A is the U.S. federal income tax code that regulates non-qualified, deferred equity compensation plans, such as stock option grants and deferred compensation. Private companies must specify an exercise price, which is the common stock that employees can purchase once they have vested), that cannot be lower than the FMV (or the value of the stock) on the date the stock rights are granted.
Because the common stock of a private company is not publicly traded on a public stock exchange, a 409A valuation is required.
According to IRS regulations, the FMV must be determined using a reasonable method at grant time. The IRS will presume that the stock’s value is a reasonable valuation method by allowing an independent third party to calculate the FMV every twelve months. The IRS considers a reasonable valuation method a “safe harbor” for the company.
The company could be subject to a severe tax penalty without a valuation safe harbor. An IRS valuation deemed unreasonable could lead tax penalties and to all employees’ deferred compensation for the current and past years being taxable immediately, with a 20% tax penalty.
Early-stage companies can hire an independent 409A appraiser who has experience in evaluating companies within their industry to establish a presumption that they are reasonable.
The company will usually be asked to provide the following information during the 409A valuation process:
Articles of incorporation
Current capitalization.
Company pitch deck,
Financials (P&L statements and bank statements, etc. ),
If there is a share purchase agreement,
Based on their hiring plan, estimate how many options they expect to issue in the next year.
“Significant Events” have occurred since the company’s last 409A valuation. This could have an impact on the company’s stock price.
Timing expectations for a potential liquidity event (e.g., acquisition, IPO, etc. ).
An appraiser will use the “market approach” 409A method to determine the company’s FMV for most publicly traded companies in their early stages. They will compare the financial information of similar publicly traded companies to determine the FMV of a company’s common stock. This includes the stock price, revenue, and earnings before interest taxes, taxes, depreciation, and amortization (EBITDA).
The appraiser will also take into account the value of preferred shares. These shares are given to investors to give them certain rights and privileges that allow them to have some control over the business model and the company’s direction.
To adjust for the stock’s liquidity, the appraiser applies a discount on the company’s common stock to make it less valuable than quickly sold stock. The company’s liquidity level will determine the discount rate.
Before issuing stock options, a company’s board must approve the most recent 409A valuation.
To maintain a safe harbor, a company must “refresh” its 409A valuation at least once every 12 months. A company must also refresh its 409A when necessary.
First, the company wants to issue standard stock options.
The company experiences a “significant event” (financing, a new business model, etc.). and,
The company is close to an IPO, merger, or acquisition.
Two reasons why the 409A+ valuation methodology is not a significant factor in a company’s pre/post-money value are:
Venture valuations often reflect the market demand. Investor demand significantly impacts the amount of capital a startup can raise.
Venture investors get preferred stock. This stock is considered more valuable because it comes with certain rights and privileges unavailable to common shareholders.
Both these reasons are why VCs often pay the per-share price higher than what an employee will have to spend to exercise their options.
However, 409A valuations are affected by pre/post-money values. If a company comes off a major fundraise, an appraiser will likely raise the 409A value. Investors can be indirectly affected by an increase in the stock option exercise price.
For VCs, it can also be helpful to see how a company approaches 409A valuation. If founders fail to follow the steps required to create a safe harbor, it could lead to severe financial trouble for the company and its employees. The IRS could bring down the company’s valuation and impose tax penalties on employee options. This could lead to a mass exodus.
Poor 409A practices can also be a hindrance to an acquisition. Regulators, bankers, and legal counsel will examine option issuances in the event of a company’s intention to IPO. It could hurt the management and be a concern for potential investors if they find them.
These are the main differences between pre/post-money and 409A valuations.
Valuation methodology. Pre-/post-money values are driven mainly by market demand and don’t usually account for the company’s 409A value. However, 409A appraisals are made by an independent third-party appraiser and are informed by the company’s post-money valuation.
Stock class. The 409A valuation represents the typical stock price. Venture investors typically receive preferred shares.
Compliance. To be eligible for IRS scrutiny, 409A valuations must meet regulatory requirements. The exact regulatory requirements apply to pre- and post-valuations.
Value change. Both pre/post-money and the 409A valuations are subject to change. The pre/post-money valuation assumes that all shares have the same value. Investors who have invested in seed shares will see their shares’ value change depending on Series A valuation. Employee stock options can be exercised at the same price as when granted.
409A valuation services can cost anywhere from $1.2k to $11k for a 409A valuation depending on the company stage. It is important to find competent third party 409a valuation providers that have much experience in providing this service. The top providers will use 409A valuation software but also ensure that the nuances of your business are accounted for, in addition to having deep industry knowledge.
Most VCs accept that pre/post-money valuations don’t apply to 409A valuations. Investors might be concerned if founders aren’t careful about keeping up-to-date 409A values. Founders must maintain 409A valuations fair market value for their employees and shareholders.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
An operating agreement is a legal document used by companies to define their organizational structure, roles and duties of owners and other key parties involved in the business, and methods for handling all transactions that occur within the company.
Stock options in startups work as a form of equity payment that allows an employee to purchase a certain number of shares of company stock at a specified price.
An over-allotment option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It’s also known as a “greenshoe option”.
Participating preferred stock is a type of preferred stock that gives the holder the option to receive dividends equal to or greater than the customarily defined rate at which preferred dividends will be paid to preferred shareholders.
