What is a 409A valuation? Why is it important, and when do you need one?
Countless startup founders have asked these questions, and yet the answers remain frustratingly long and tedious. Like so many tax-related topics, 409A valuations are in desperate need of a rebrand. The term derives not from a jumble of numbers and letters picked from a hat, but from Section 409A of the Internal Revenue Code, which regulates nonqualified deferred compensation paid to plan participants.
Bored yet? Let’s break down the essential things you need to know about this complicated topic.
1. A 409A Valuation Protects Employees and Contractors Who Own Common Stock in Your Company
In plain English, 409A is about stock options. Specifically, 409A covers common stock rather than the preferred stock investors typically receive. When you give employees or independent contractors equity in your private company, the law obligates you to issue options or sell shares at a fair market value.
If the IRS determines that you’ve undervalued your stock, any employee or contractor who obtained the mispriced options or shares may well need to pay back taxes, face potential fines and associated interest.
In order to prevent that from happening, your company will need to determine the value of its common stock at the time of an option issuance or stock sale. The process of figuring out what your stock is worth at that time is what’s known as a 409A valuation.
2. 409A Valuations Are Not Simple Math
It’s relatively easy to ballpark the value of a public company: just take the company’s current stock price and multiply it by the number of shareholders. But with private companies, the stock is not actively being sold in a marketplace or exchange and therefore is illiquid. Without actual stock buy/sell transactions, it’s much more difficult to determine a fair valuation.
Valuation methods may take into account revenue and cash flow, current assets, how similar organizations compare, what investors paid during your last equity round or other factors. Methods typically consider some or even all of these approaches and apply weighting factors to reach as informed an answer as possible.
Companies typically end up valued somewhere within a range. A 409A valuation sets the value of a company’s common stock at a specific number.
3. Your Goal During a 409A Valuation Is to Ensure Compliance
However it’s calculated, your 409A valuation needs to be defensible. If your company’s value looks suspicious or out of whack, the IRS may well decide to audit you.
The lower your valuation, the lower the strike price you can offer your employees and contractors who want to buy stock in your company. A low strike price maximizes buy-in while giving shareholders’ equity more room to grow. There’s an understandable attraction for companies to want a lower valuation, but you should defer to the valuation agent for a clear indication of value.
4. Certain Moments in Your Startup’s Lifecycle Require You to Get a 409A Valuation
Although 409A valuations are required by law, timing is everything. If you don’t need a valuation, don’t rush to get one. If you do need one, don’t postpone it.
You need to get a 409A valuation…
- if you intend to award common stock options,
- after any new funding round, or
- whenever equity owners start selling company shares.
Keep in mind that once you’ve gotten your first valuation, your company enters an infinite loop. After your first valuation, you’ll need a “refresh” every 12 months. Additionally, after your first valuation, there can be other significant events that necessitate a new valuation. Select a valuation agent that can provide advice and consult your lawyer to determine if certain events should trigger a re-valuation.
5. A 409A Valuation Often Differs From an Investor’s Valuation of Your Company
A 409A valuation is not equivalent to what an investor may decide your company is worth, nor is it a great sales tool for potential investors.
The 409A is a valuation of common stock, but investors typically have preferred stock that comes with additional rights and controls and is therefore valued on a different basis. So while a 409A may appear lower than an investor’s valuation, remember they are valuing from separate perspectives.
6. Find An Independent Provider to Do a 409A Valuation
Notice that phrase above: “calculated carefully by experienced professionals.” If you aren’t a skilled, trained, and credentialed valuation analyst, it’s a bad idea to take on a 409A valuation alone. When you use a qualified financial advisor or independent provider, your company maintains safe harbor status: you’re almost guaranteed not to undergo an audit. In the rare event that you do, your advisor or provider can furnish defensible proof of compliance.
7. Not All 409A Valuation Providers Are Equal
To get a proper 409A valuation, startups rely on either a qualified financial advisor or independent analysts. Very, very early startups could have a CFO or another financial professional handle the task, but it’s almost never worth the time or expense. Most startups look to third-party firms, like Carta or Simple409A, with years of experience and the proper credentials.
Choose your valuation provider carefully. Prices vary, and a deal that looks too good to be true probably is. While you shouldn’t pay exorbitant fees for a 409A valuation, some low-cost providers lack the experience and track record necessary to ensure compliance. Be sure to work with a provider with the right certifications, background, and terms of engagement.
8. Get A Trusted Advisor To Help Navigate Your 409A Valuation
No 409A valuation is over in a day. (If it is, that’s a sign something is very, very wrong.) Expect the process to last at least a couple weeks.
You can speed things up by preparing all your financial information beforehand and working with a trusted financial partner, like inDinero. Our team of CFOs and controllers will help discuss the valuation methodologies, provide input to the valuation process, review the draft valuation report, and approve the final report. In fact, we've worked with hundreds of companies that have gone through this process. Schedule time to talk with us and we can make sure that your business is set up to scale before and after your 409A valuation.