Everything you need to know about 409A Valuation

The 409A valuation can often feel like a black box to many people. It has changed a lot over the 15 years since it was first introduced. It used to be a hodgepodge of now-outdated techniques and loose ranges. But now it is a set of more established, well-defined methodologies and inputs. The 409A valuation is the only method you can use to grant options on a tax-free basis to your employees.

What is 409a Valuation

What is 409A Valuation?

A 409A valuation is conducted to determine the fair market value of a company's common stock. This valuation will be used to set the strike price for options offered to anyone issued with common stock. In most cases, this will be done by a specialist firm that provides valuations, and will typically take place around significant events such as a new round of financing.

The Internal Revenue Service's 409A has given startups the framework they need to price their options. Today, they're required to value their company and shares so that they can determine the value of the options they issue to employees.

What Is 409A Valuation Used For?

A 409A valuation is required by law to maintain compliance for your company. Non-compliance can result in significant penalties from the IRS, such as undervaluing stock options, which could lead to lost compensation.

If your company is about to have a significant transaction that involves stock, you'll need to get a 409A valuation. This will help substantiate the Fair Market Value of the shares. Some examples of significant transactions that would require a 409A valuation are:

  • Availability of multiple options to employees
  • Availability of multiple options to advisors
  • Undertaking new investment rounds
  • Issuing shares while entering into a partnership

What Is a 409A Valuation Report?

A 409A valuation is an in-depth appraisal of a private company’s stock in preparation for issuing shares. This process provides all the details of the valuation so that the company can make an informed decision. At an early stage, rounds of financing are closely monitored. This is because when professional investors are brought in to price the round, it sets a standard by which the company will be measured. In addition to this, financial projections will be looked at to get a sense of the company's growth. For mature companies, this is easier to do as their projections can be compared to public companies. However, for early-stage companies, there is more volatility in their forecast. Therefore, the preference stack in the cap table also needs to be taken into account when determining the company's valuation.

There is no one specific way that a 409a valuation report must be formatted as every company has its way of conveying information. Additionally, since the IRS did not provide formal guidelines on what must be included in a startup 409A valuation report, there is no definitive template. However, key components that should be included in the report are the valuation amount, methods used to arrive at the value, and information about the company conducting the valuation.

What Is Needed to Do a 409A Valuation?

As an early-stage company, we pay close attention to the rounds of financing. This is because when you have professional investors pricing the round, it provides a benchmark for future success. In addition to this, we also look at financial projections, as they can be used to compare and contrast a mature company against public comps. However, it's important to keep in mind that for earlier-stage companies, there is often more volatility in the forecast. Another factor that needs to be taken into account when determining the value of a company is the preference stack in the cap table for those startups that have raised capital.

The 409A valuation report would include all the key details about the methods used to assess the FMV of company shares, as well as how all the data was analyzed. You can find information in the report ranging from the capital structure of the company to its industry. In total, the report would be around 40 to 80 pages.

Some things you would find in a 409A valuation report include:

  • 1. Summary of Findings: The findings and value for the shares of common stock are usually discussed in this section of the 409A valuation report. This is usually the section that company management is most interested in. However, the next sections are also just as important in making the IRC 409A valuation defensible when it is audited.
  • 2. Valuation Overview: This section will reveal the details of the methods used for valuation, what the outcome was, and the differences between each method. This will include insights into the asset, income, and market approaches.
  • 3. Firm history: This part of the website delves into the company's backstory, offering visitors a chance to learn about what led the company to where it is today. All of the important details are here, including information on the company's product offerings, market share, competition, and future growth outlook.
  • 4. Ownership and Management: This section provides an overview of the management team and equity structure at the company. Additionally, it includes key employees and details on the management structure.
  • 5. Structure of Capital: Capital structure is important to understand to get a grasp on a company's financial stability and overall health. This section provides helpful tables and charts that break down a company's equity securities and classes, as well as its income statement and balance sheet. Having this information readily available will give you key insights into how the company is doing and where it might be headed in the future.
  • 6. National economy: This section provides an overview of the national economy and the company's industry. It covers the output and effects of the industry on the economy, as well as how the economy has changed in recent years.
  • 7. Industry: The evaluator's role is to provide a detailed overview of the industry and product/service landscape so that future decisions can be made about the company's place within it. This understanding of the industry leaders and what the company offers in comparison helps to not only assess where the company stands to others but also what types of products and services are currently being offered by the market.
  • 8. Analysis of finance: This section gives a comprehensive financial analysis of the company by using the historical income statements and balance sheet of the company. It would also include common-size financial statements compared to others in the industry, to give a more accurate picture of the company's financial standings.

A 409A valuation is not only about getting the value of the company as of today but also about understanding how the company compares to others in the industry. This valuation process takes into account the larger picture of the environment and economy in which the company is operating, to help build a more accurate picture of the company's worth.