How much is a share of your company worth to you? The market sets the value for public companies. Private companies, however, rely on independent appraisers. Hopefully, someday those stock options will be worth a boatload for you, your employees, and your investors. However, you need to set a basis for the company to issue the stock.
A 409A appraisal is an independent assessment of the fair value (FMV) of a private company’s stock (stock reserved mainly for founders or employees). This valuation is based on section 409A (internal revenue code) of the IRS. It determines the cost to buy a share.
What is the 409A valuation?
You will need a 409A appraisal if you plan to offer equity before you can issue common stock options. To avoid tax penalties from the IRS, early-stage companies and founders need 409A valuations. A reputable 409A valuation service can help you to take advantage of “safe harbors”.
A 409A valuation is a must.
- Before you issue your first common stock option
- After raising a round of venture financing
- Every 12 months or after a material incident
You are considering an IPO, merger, or acquisition?
IRC 409A valuations will be valid for 12 months or until a material change occurs. A material event is anything that can affect the stock price of a company.
A “qualified financing” is the most common material event for startups in their early stages. Qualified financing usually involves the sale of common shares, preferred stock, or convertible debt at a predetermined price to institutional investors.
What is a 409A event?
Other events, aside from financing, may be considered important:
- An important, new or lost contract that is significant and represents a material shift in revenue (ARR).
- Any closed, material acquisition between your company and the buyer/seller
- A potential buyer provided a term sheet to your company.
- A strategic partnership that opens new markets and improves margins.
- Regulations that can significantly increase or decrease the size of your market.
What is IRC Section 409A?
The 2001 Enron scam prompted regulators to look for ways to stop executives from using equity loopholes. In 2005, the IRS introduced IRC Section 409A; a final version was in effect in 2009.
Section 409A provides a framework that private companies can use to value private stock. It establishes a safe harbor, which means that the IRS presumes the valuation to be reasonable if it is done by an unaffiliated party or independent party. There are a few exceptions.
The IRS can impose penalties on companies that don’t follow the 409A rules or price equity incorrectly. Most often, shareholders and employees end up paying.
What is the cost of a 409A appraisal?
Some companies offer 409A valuations as a standalone service, while others offer bundles. Depending on the complexity and size of your company, standalone valuations can cost anywhere from $1,000 up to $10,000.
The leading vendor in this space is Carta, but there are others as well.
What is a 409A Refresh?
Your company will require a 409A refresh after 12 months or sooner if there is a material event. In other words, a new valuation. You will need a new 409A for any event that could affect the company’s valuation.
What is a safe harbor in 409A?
Your 409A will be eligible for “safe harbour” status if it is treated in a certain way. It’s like having peace of mind. A safe harbor valuation is one that the IRS assumes to be valid, unless it can be proven otherwise.
Three safe harbor options are available to the IRS for setting FMV for private company common shares.
- Independent appraisal presumption
- Presumption of binding formula
- Illiquid startup presumption
Safe harbor status can be achieved by using the independent appraisal presumption (a qualified third-party appraiser).
If the stock was valued within twelve months of the applicable option grant dates and there has been no material change between the valuation date, and the grant date, a 409A valuation will be presumed reasonable. These requirements being met, the IRS must prove that the valuation was “grossly unreasonable”.
Common 409A methods
Independent appraisers are required to verify that your FMV and 409A are “fair.” There are three types of standard methodologies that providers can use in a 409A: the market approach, income approach and asset approach.
- Market approach (OPM backsolve). – Valuation providers often use the option pricing method (OPM) backsolve when valuing your company’s financing round. You can safely assume that investors pay fair market value for equity but investors get preferred stock. To determine the FMV of common stock, adjustments should be made. Another market-based approach uses financial information such as revenue, net income and EBITDA (earnings after interest, taxes and amortization) from similar public companies to determine the company’s equity valuation.
- Income approach – Valuation providers commonly use the simple income approach for businesses that have sufficient revenue and positive cash flows. This method determines a company’s worth based on its future cash flows adjusted for risk.
- Asset approach – This approach is used often for companies in early stages that have not raised any money or generated revenue. This method calculates the company’s net assets value to determine a true valuation.
What information do I need to get a 409A appraisal?
After you have selected a 409A appraiser you will need to compile some information about your company and share it.
Information about the company
Name of your CEO
If applicable, name of your external auditor firm
Name of your legal counsel
Your amended and restated articles
Information about the industry
Your industry
A list of comparable and relevant public companies (Most 409A values rely on some type of comparison to publicly traded corporations)
Options and fundraising
The most likely timing for a liquidity event
Your executive summary, business plan or presentation of your company
Financial statements of companies
Historical financial statements
Forecasted revenue for 12 months starting at the valuation date and continuing through the next two calendar year
Forecasted EBITDA (EBITDA) for the next 12 month, starting at the valuation date and continuing through the next two calendar year
Cash burn and runway
Non-convertible debt amount
409A penalties
If your valuation is not performed using an IRS-approved method, you may be exempt from the 409A safe harbor. Employees and shareholders can face severe penalties
- All deferred compensation for the current and previous years is taxable immediately
- Accrued Interest on the Revised Taxable Amount
- All deferred compensation is subject to an additional 20% tax
The IRS is unlikely to audit most startups. However, it is possible that you will be audited by the IRS as your company grows or if you plan to exit (such as a merger, acquisition, or IPO). Working with a trusted valuation provider will save you time and help you avoid unnecessary headaches.
Other Resources
- Andreessen Horowitz – 16 Things To Know About The 409A Valuation