When startups grant stock options – which are important for attracting talent – how do they determine the value of common shares? For a privately-held company, the 409A valuation is the only method you can use to grant options on a tax-free basis to your employees. We share the basics of the 409A valuation. After you read this article, you will learn:
When do you need a 409A valuation?
How do auditors determine the price of shares in a 409A valuation?
Common myths on 409As
What is a 409A?
A 409A valuation is an independent appraisal of your company that sets the price of your startup's shares. Any company issuing stock options needs a 409A valuation - this includes most startups who grant options as part of employee comp. When you grant stock options to employees, you need a value to determine the value of these shares. For public companies, this is the stock price. For private companies, an independent 409A valuation is the only method to grant options on a tax-free basis to your employees.
How often do I need a 409A valuation?
A 409A valuation report is valid up to 12 months from the valuation date or when a material event occurs – such as a new funding round. With companies raising new rounds frequently, Pulley includes multiple 409A valuations in our Growth plans so you can plan ahead.
How do I evaluate my 409a valuation firm?
Picking the right auditor is important to keeping your valuation is defensible.
Track-record - Ask your auditor if their valuations have stood up against the big four auditing firms, the IRS, and SEC. Pick a valuation firm with a track record of audit-proof valuations.
Domain - Pick a valuation firm that has experience valuing your industry. For example, if you are a high-growth startup, don't pick an auditor in the south who is used to valuing profitable small businesses. The valuation will take longer and is less likely to be accurate.
Guarantee - Pulley offers all companies free lifetime audit review support at no additional cost. We stand by our reports.
Be wary of low-cost valuation firms. Some 409A valuation firms use automated statistical models to provide fast, low-cost reports. This comes with two risks:
Overvalued shares - Low-cost providers reduce compliance risk by over-pricing shares by almost 30–50%. This can de-motivate employees and defeats the purpose of granting equity to attract great talent.
Due diligence - 409A compliance is part of the due diligence for every investor and acquirer. A missing or non-compliant report addition can delay or deter future investors.
Pick an auditor who will research your business to accurately access its value. We connect you with experts who understand your business to give all companies a fair and defensible 409A report.
How is a 409A valuation calculated?
There are three steps in a 409A valuation:
Calculate company value - High growth, unprofitable tech companies often use the market approach. In this approach, your auditor finds public companies in your domain and applies the valuation multiple to your own metrics.
Determine the value of the common stock - The second step is to take that company value and divide it against all the shares within the different share classes. This is more complicated than it seems because different shares (preferred) have different economic rights.
Apply a discount for lack of marketability (DLOM) - Your shares are not tradable if the company is private. Your auditor will then apply a discount to your share price because there is no liquid market to sell these shares.
How do I lower my strike price?
If anyone tells you your 409A is too high and should be “X% of the preferred,” they’re giving outdated advice. There is no standard 409A valuation.
Startups can no longer just use a rule of thumb to set common stock FMV at 10-20% of the most recent preferred round. Only in rare instances is a company's common stock legitimately 10-20% of the value of its preferred stock. The ratio of common to preferred depends on a multitude of factors - economic conditions at the time of the fundraising and valuation, company growth, and more.
That said, companies should review their 409A valuation and the underlying assumptions. There may be incorrect assumptions about the market and growth that affect your company's value.
Keep in mind that the goal of a 409A valuation is not getting the lowest valuation. It's to receive the lowest defensible valuation that stands up against the big four auditing firms and the IRS.
Understanding the costs of non-compliance with 409A
409A valuations are a necessary part of growing a team. There can be severe financial consequences for your employees for non-compliance. If the IRS determined your 409A valuation does not need standards, all of the shares you granted to employees at that value would be subject to gross income tax. The IRS can also levy up to a 20% penalty on stock options on top of the back-tax.
While enforcements are rare, the IRS has successfully pursued cases in the past (See Credit Karma). 409A compliance is part of the due diligence for every investor and acquirer. A missing or non-compliant report addition can delay or deter future investors.
Getting your 409A through Pulley
Pulley onboards your cap table - An up-to-date cap table is required for your 409A. Our cap table experts can create your cap table from a spreadsheet, Clerky, Carta, or documents.
Request a 409A valuation - Once you request your 409A valuation on Pulley and submit the required information, a valuation expert will reach out if they need additional information or context.
Receive your report - The valuation report will be delivered within 5-7 business days after all relevant information has been gathered. Once you receive your initial draft you will receive an email that discusses next steps including who to contact if you have questions about the draft report. The report can be finalized at any time by accepting the valuation in your account.
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