409A Valuation: A Founder’s Guide

409A Valuation for Startups — What Every Founder Should Know

Employee stock option plans (ESOPs) are a popular equity compensation strategy adopted by startups and high-growth companies.

But, how is the value of these ESOPs evaluated?

It’s evaluated by doing a 409A Valuation.

Now, you’ve heard of the 409A Valuation before.. And got some chills hearing it, right?

But you know, it’s easy. Trust us. This blog will help you understand it step by step. Let’s go!

What is a 409A Valuation?

A 409A valuation is an assessment of the fair market value (FMV) of a private company’s common stock. Conducted by a third-party firm, this evaluation determines the minimum exercise price that a company can attach to its stock options.

It is essential for compliance purposes to adhere to the rules and regulations of the Internal Revenue Service (IRS). So, for anybody extending stock options to employees based in the US, conducting a 409A valuation is non-negotiable. Not performing one may attract tax penalties.

When Must a 409A Valuation Be Done?

If you’re extending stock options to your employees, you need to get a 409A valuation done beforehand.

Also, companies must get their 409A valuation done annually. And in case there’s an event, such as a new funding round or a key milestone, then the valuation must be done before such an event.

There’s basically a 409A valuation report that is made, which has everything related to the valuation done. It includes the valuation of the course, the methodology used to evaluate the valuation, and what all has contributed to the company attaining the said valuation.

Important: If company options are granted below the FMV without a 409A valuation, employees could face significant tax penalties, which include immediate taxation and an additional 20% federal tax.

Safe Harbour Status

There’s something called the safe harbour status for companies getting a 409A valuation done.

Getting your valuation done by an independent and reputable 409A valuation provider helps you secure a safe harbour status with the IRS for your firm. And what does that imply?

It implies that the valuation you have determined for your company is reasonable and audit-defensible. This protects you from any penalties related to your stock option pricing.

409A Penalties

Penalties can be hard.

If you fail to perform your 409A valuation by using one of the IRS-approved methods, you most definitely could attract a penalty.

What are the penalties?

• All current compensation from the current and previous years becomes subject to taxation
• There’s also accrued interest on the revised taxable amount
• An Additional 20% tax is levied on all deferred compensation
• Employees may also be subject to hefty penalties, which can decrease employee morale
• Not having a 409A valuation can damage your reputation.

How to Calculate 409A?

There are some methodologies used to calculate 409A. Let’s discuss the most common ones next.

1. Market Approach (OPM Backsolve)

If you go for the market approach, the appraiser will compare your company to similar companies. These may be companies that have recently been acquired to companies that have recently become public. The appraiser will analyze the transaction data of such companies to estimate the FMV of your company.

This method fits if there are companies available that can be compared to your company (They are at a similar stage of growth as yours).

Also, the method is ideal for early-stage startups that have difficulty forecasting long-term financial performance.

(P.S.: OPM stands for Option Pricing Method)

2. Income Approach

In the income approach, the appraiser uses a company’s projected future cash flows to estimate the company’s current value.

So, in this, the appraiser forecasts the future revenue and expenses and then discounts the cash flows to the present value using a discount rate.

This method is popular among companies with predictable revenue streams and sufficient cash flow.

3. Asset Approach (Cost Approach)

In this approach, a company’s value is derived from its individual assets, both tangible and intangible. The assets may include property, equipment, inventory, Intangible property, and also the brand value.

So the FMV of each asset is assessed and the sum is totalled to get the valuation of a company.

Note: The appraiser may also resort to a combination of these methodologies to arrive at a more accurate valuation.

How to Prepare For 409A Valuation?

• You must have 1-3 years of audited balance sheets, income statements, and cash flow statements.
• Recording and storing a company’s past performance is crucial.
• Your capitalization table (cap table) must be up-to-date, detailing the ownership structure of the company, the number of shares issued, ownership percentages, etc.
• If you’ve received any funding earlier, you must also have it clearly laid out.
• Lay out your business plan, future strategies, and projected performance.

You might wonder, is getting this valuation done a strain on finances? Well, that depends.

The cost of getting a 409A valuation done is subject to many things.

• From whom are you getting your valuation done?
• What is the size and scale of your company?

But, just to give you an idea, it can range from $1,000 to over $10,000.

Now, there are some mistakes that companies often commit while evaluating 409A valuation. Take a look.

Mistakes to Avoid

• Ensure you provide the appraiser with all your financial information/documents
• Provide a detailed business plan and roadmap of your company
• Once you get the report, don’t blindly trust it. Go through it properly and ensure it has all the right information. The report may have errors or inconsistencies. Be careful.
• Document everything, the entire process of getting the valuation done. The assumptions made during calculations, the assets analyzed, the ongoing market conditions, etc. Documenting this will help you in future audits.

Summing Up

And that’s about it! That’s how a 409A valuation works.

Consult an independent third-party appraiser. Disclose relevant information related to the company’s finances, future goals, competitors, and potential.

It’s not as complex as you initially thought it would be, right?

Frequently Asked Questions