Startup finance guide: 409A valuations (definition, triggers, examples)
Learn how often your startup will need a 409A valuation, the risk factors that these valuations look for, and how to choose the right firm.
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1 minute
August 8, 2024
Actively complying with tax codes is one of the most important actions a startup founder and chief financial officer can take to protect the company and its employees. Knowing the importance of 409A valuations, the ins and outs of why a startup might need one, and how to prepare to get one is crucial to comply with Section 409A of the Internal Revenue Code (IRC).
In this guide, designed for first-time founders, we’ll cover all of these questions and more.
Key highlights:
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Isabel Peña Alfaro is a guest contributor. The views expressed are hers and do not necessarily reflect the views of Rho.
A 409A valuation is an assessment or evaluation of the fair market value (FMV) of a private company's common stock, and it is conducted by a third party. It is required under Section 409A of the IRC to set the strike price for stock options issued to employees, consultants, and other service providers.
To give you a little background:
The 409A valuation requirement was introduced as part of the American Jobs Creation Act of 2004, following the Enron accounting scandal. Enron had allowed employees to backdate stock options, granting them at favorable low prices before a rise in the company's stock value.
Section 409A aimed to prevent such abuses by requiring companies to obtain an independent assessment of the FMV for their common stock when issuing stock options. Failure to comply with 409A can result in significant tax penalties for both the company and the option recipients.
A 409A valuation and a post-money/venture valuation serve different purposes and are calculated using distinct methodologies.
Let’s compare them.
On the one hand, the 409A valuation has rigorous calculation methodologies. The three main approaches are the income approach, the market approach, and the asset approach to arrive at a conservative FMV estimate based on the company's current financial performance and market conditions.
On the other hand, a post-money valuation, also known as a venture valuation, represents the estimated worth of a company after an investment round or funding event. It reflects the future growth potential and market opportunities perceived by investors, factoring in the new capital infusion and ownership dilution.
Post-money valuations are typically negotiated between the company and investors during fundraising rounds. They tend to be higher than the 409A valuation for a few key reasons, including growth potential, investor expectations, timing, methodology, and risk tolerance.
While post-money valuations are generally higher, they are still subject to negotiation and due diligence by investors. A company with strong growth prospects, a solid business model and plan, and a capable team is more likely to command a higher post-money valuation during fundraising.
Typically, a 409A valuation is valid for 12 months from the valuation date, unless a material event occurs that could significantly impact the company's value.
If a material event — such as a stock issuance, a new funding round, acquisition, or significant change in business strategy — takes place within the 12-month period, the existing 409A valuation becomes invalid.
The company should then obtain a new valuation to reflect the impact of the material event on the fair market value of its common stock.
A 409A refresh refers to obtaining an updated 409A valuation for a private company's common stock every 12 months from the date of their previous valuation. As mentioned earlier, a 409A valuation only remains valid for 12 months under IRS regulations. Remember that a 409A refresh is required sooner than 12 months if the company experiences a material event.
Most 409A valuation firms charge within the $2,500 to $4,000 range for a thorough, defensible valuation that meets IRS safe harbor requirements. Some providers offer expedited valuation services for an additional fee. For very large, complex companies, costs can escalate to $10,000 or more.
A 409A safe harbor refers to obtaining a 409A valuation that is presumed to be reasonable and accurate by the IRS. To get safe harbor status, a qualified, independent appraiser should conduct the 409A valuation by using appropriate valuation methods.
A safe harbor provides legal protection against potential penalties for non-compliance with Section 409A regulations. In other words, if a company has a safe harbor 409A valuation, the burden of proof falls on the IRS to demonstrate that the valuation was grossly unreasonable, rather than on the company to justify its valuation approach.
409A non-compliance can result in severe tax consequences for employees receiving non-qualified deferred compensation (NQDC). Employees face accelerated taxation on their deferred compensation, plus a punitive 20% additional tax and interest charges.
Employers, on the other hand, have to withhold income and payroll taxes on the amount of deferred compensation that is included in the employee's income. Employers may also need to refile previous years' tax forms (W-2s, 1099s) to accurately report the deferred compensation amounts included in income.
Why do penalties fall primarily on employees?
The penalties primarily fall on employees because the deferred compensation is considered their income. The IRS holds employees responsible for paying taxes on their income, even if the company’s plan is non-compliant.
However, employers have obligations to withhold and report this income correctly, and failure to do so can result in penalties for the company as well.
These are key reasons why a startup may need a 409A valuation.
Let’s go over them.
Valuation firms typically focus on applying accepted methodologies to determine the FMV of the company's common stock. They analyze the company's financial statements, business plans, industry analysis, capital structure, and any material events that could impact valuation.
They also consider the company's stage of development, funding history, and future liquidity prospects, such as an IPO.
The goal is to arrive at a defensible FMV estimate that complies with IRS regulations and provides a legal safe harbor for setting employee stock option prices.
Firms typically look for key risk factors that could significantly impact the FMV of the company's common stock.
These risk factors include:
They also assess risks stemming from the company's stage of development, with early-stage companies often facing higher uncertainty than established businesses with proven performance.
Evaluating these risk factors helps the 409A valuation provider arrive at an appropriate discount rate and lack of marketability discount, which is a discount or reduction applied to the value of a private company's shares/ownership interests, to apply in their valuation models.
The market approach, specifically the Option Pricing Method (OPM) backsolve, is one of the most commonly used methods for 409A startup valuations. It treats the company's equity as a call option on the company's value, with different classes of stock representing different call options with varying strike prices and dividend rights.
Note that multiples play an important role in the 409A valuation process, particularly when using the market approach methodology.
The OPM backsolve method starts with the most recent preferred stock pricing from a funding round to derive the total equity value of the company. It then allocates this equity value across the various securities in the capital structure (preferred shares, common stock, options, etc.) based on their respective rights and preferences.
This allows the appraiser to determine the FMV of the common stock, which sets the strike price for employee stock options in compliance with 409A regulations.
The income approach is used for startups that have established revenue streams and predictable cash flows. It estimates the company's FMV by projecting its future earnings or cash flows and discounting them back to their present value using an appropriate discount rate.
Under the income approach, the valuation firm forecasts the startup's future cash flows over a period of typically 5-10 years, based on its historical performance, growth projections, and market conditions.
Then, the projected cash flows are reduced to their net present value using a risk-adjusted discount rate that accounts for the company's stage, industry risks, cost of capital, and other factors.
The asset approach is particularly used for early-stage startups or asset-heavy companies. This approach determines the FMV of a startup by calculating the sum of its assets minus its liabilities.
Under the asset approach, the valuation firm identifies and values all of the startup's tangible assets, such as cash, equipment, and real estate. It also identifies intangible assets, such as intellectual property, patents, and trademarks. The appraiser then subtracts the company's liabilities from the total asset value to arrive at an estimate of the startup's overall FMV.
Consider the following key criteria:
To prepare for a 409A valuation, a startup should gather and provide the following key information and documents to the independent third-party appraiser:
Note: The startup should also be prepared to discuss its growth strategy, competitive landscape, potential exit scenarios, and any other factors that could impact its valuation.
Providing complete, accurate, and transparent information is crucial for the appraiser to conduct a thorough analysis and arrive at a defensible 409A valuation that meets IRS safe harbor requirements.
As an aside: For private companies, especially startups, maintaining an accurate and up-to-date cap table is crucial for equity management, investor reporting and disclosures, valuations, tax code compliance, and facilitating future financing rounds or exit events. As a company's equity structure gets more complex over time, a well-organized cap table becomes indispensable.
There is no universal "rule of thumb" or formula to determine what a startup's 409A valuation should be based on specific factors. This is a myth, as 409A valuations are complex analyses that should consider the totality of a company's unique circumstances.
There is no simple calculation or benchmark that can accurately capture the value of a private company. Each 409A valuation is a rigorous, case-by-case analysis to ensure compliance with IRS regulations and establish a defensible fair market value.
The notion that you can't perform a 409A valuation yourself is a myth, but attempting to do so is generally a bad idea that could put your company and employees at significant risk.
While there is no explicit prohibition on founders conducting their own 409A valuations, the IRS requires these valuations to be performed by a qualified, independent third-party appraiser using accepted valuation methodologies.
In other words:
Attempting a 409A valuation yourself, without the proper expertise and objectivity, increases the likelihood of an inaccurate or unreasonable valuation that fails to meet IRS safe harbor standards. This could expose your company to potential IRS penalties and audits, as well as unexpected tax liabilities for employees who received stock options based on an improper valuation.
That’s why engaging a reputable, independent valuation firm ensures compliance with complex 409A regulations and protects both your business and employees from costly consequences.
The notion that you're not required to issue stock options at the price determined by a 409A valuation is a myth that could put your company at significant risk of IRS penalties and audits.
The 409A valuation establishes this FMV using accepted valuation methodologies. Intentionally issuing options at a strike price below the 409A valuation price violates 409A regulations and strips the company of its legal "safe harbor" protection.
This could trigger severe tax consequences, such as immediate income taxation of the full option value for employees, an additional 20% tax penalty, and potential interest charges and IRS audits for the company.
Venture capitalist (VC) valuations assess the company's future growth potential and upside when negotiating investment terms and pricing preferred stock rounds. VCs understand that 409A valuations, by design, do not fully capture the company's projected execution and exit opportunities that drive returns on their investments.
Also, 409A valuations have to follow specific IRS guidelines and valuation methodologies that may not align with the VCs' own financial models and assumptions used in their investment thesis.
While extremely low 409A valuations could raise governance concerns, VCs primarily conduct their own rigorous due diligence to analyze the startup's products, markets, and financial projections when determining a fair valuation for their investment.
That’s why VCs generally do not place significant weight on a startup's 409A valuation when making investment decisions.
While there’s no specific template for a 409A report, here is an example of what a 409A valuation report for a startup might look like:
Executive Summary (summary of findings)
Engagement Description (purpose and scope)
Company Overview
Valuation Methodologies
Valuation Calculations
Valuation Conclusion
The level of detail can vary, but a comprehensive 409A report carefully documents the valuation process, methodologies used, and how the FMV conclusion was reached based on the startup's specific facts and circumstances.
Limited Liability Companies (LLCs) are subject to 409A valuations even though they do not issue traditional shares of stock. When granting equity-based compensation like options or profits interests to employees or service providers, LLCs should obtain a 409A valuation to determine the FMV of the company's ownership interests.
There is no universally "correct" level for a 409A valuation to be high or low.
The key is for the valuation to accurately reflect the FMV of the company's common stock based on its current financial performance, future projections, and other relevant factors analyzed through accepted valuation methodologies.
Now, a valuation that is artificially low could trigger IRS scrutiny and penalties, while an inflated valuation could make it difficult to incentivize employees with affordable stock options. The goal is to obtain an independent, well-supported 409A valuation that provides a defensible "safe harbor" for setting option prices in compliance with IRS regulations.
No, 409A valuations are not public documents. The valuation reports contain confidential financial information and projections about the private company that are typically only shared with the company's board of directors, executives, legal counsel, and accounting advisors.
409A valuations are not filed or disclosed to the IRS or any other public agency, though the IRS may request to review the valuation during an audit. Keeping 409A valuations private protects the company's competitive position while still allowing it to comply with IRS regulations around stock compensation.
There are several common triggers that require a startup to obtain a 409A valuation.
Some of these triggers include:
As an aside, public companies and publicly traded companies do not need to obtain 409A valuations. 409A valuations are specifically required for private companies that issue stock options or other equity compensation to employees and service providers.
A 409A valuation is valid for 12 months from the date it was conducted. However, the validity period can be shorter if the company undergoes a material event or change that could significantly impact its valuation, such as a major funding round, new product launch, merger/acquisition, or any other development.
While there may be no legal requirement to share a private company's 409A valuation details with employees, many experts recommend doing so as a best practice for transparency and employee engagement.
Providing some high-level context around the valuation methodology used and key drivers impacting the company's FMV can help employees better understand the value of their equity compensation.
However, companies may want to limit sharing full valuation reports containing sensitive financial projections and assumptions. The goal should be educating employees on the equity value they are earning without disclosing confidential information that could be detrimental if made public.
409A valuations are critical for startups to establish the FMV of their common stock and ensure compliance with IRS regulations when issuing stock options and other equity compensation.
These independent third-party valuations, conducted annually or after material events, analyze the company's financial performance, projections, capital structure, and market position. A proper 409A valuation provides legal safe harbor protection and allows the startup to avoid severe tax penalties, among other benefits.
As you prepare for a 409A valuation, it’s important to take a load off your finance team. Rho makes finance frictionless for organizations. Learn more here.
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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.