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 company 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 409A valuation, an independent valuation of the private company’s common stock by a third party, informs the price for employee stock options.
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.
Every time the company seeks to raise new funding, 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 value.
The pre/post-money and 409A affect each other in important ways that VCs need to understand. This guide will provide information investors need about 409A valuations. It will also explain why they are essential, 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 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 a 409A valuation.
Section409A is the U.S. federal income tax code that regulates non-qualified, deferred equity compensation plans, such as stock option grants. 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 reasonable 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 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:
An appraiser will use the “market approach” 409A method to determine the company’s FMV for most 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 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.
Two reasons why the 409A valuation is not a significant factor in a company’s pre/post-money value are:
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 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.
409A providers can charge anywhere from $1.2k to $11k for a 409A valuation depending on the company stage.
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 for their employees and shareholders.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.