Calculating the 409A Value
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.
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The company will usually be asked to provide the following information during the 409A valuation process:
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Articles of incorporation
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Current capitalization.
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Company pitch deck,
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Financials (P&L statements and bank statements, etc. ),
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If there is a share purchase agreement,
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Based on their hiring plan, estimate how many options they expect to issue in the next year.
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“Significant Events” have occurred since the company’s last 409A valuation. This could have an impact on the company’s stock price.
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Timing expectations for a potential liquidity event (e.g., acquisition, IPO, etc. ).
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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).
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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.
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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.
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Before issuing stock options, a company’s board must approve the most recent 409A valuation.
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To maintain a safe harbor, a company must “refreshโ its 409A valuation at least once every 12 months. A company must also refresh its 409A when necessary.
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First, the company wants to issue standard stock options.
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The company experiences a “significant event” (financing, a new business model, etc.). and,
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The company is close to an IPO, merger, or acquisition.
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Why should VCs care about the 409A valuation?
Two reasons why the 409A+ valuation methodology is not a significant factor in a company’s pre/post-money value are:
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Venture valuations often reflect the market demand. Investor demand significantly impacts the amount of capital a startup can raise.
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Venture investors get preferred stock. This stock is considered more valuable because it comes with certain rights and privileges unavailable to common shareholders.
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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.
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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.
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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.
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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.
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409A Value vs. Venture
These are the main differences between pre/post-money and 409A valuations.
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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.
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Stock class. The 409A valuation represents the typical stock price. Venture investors typically receive preferred shares.
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Compliance. To be eligible for IRS scrutiny, 409A valuations must meet regulatory requirements. The exact regulatory requirements apply to pre- and post-valuations.
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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.
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What Does a 409A Value Cost?
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.
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Bottom line
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.
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To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
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