What Is a 409A Valuation? A Guide for Startup Founders
Say you’re the founder of an early-stage startup and you want to attract the best talent in the world to work for your company. You have a great product and a compelling mission statement, which is a start. But you won’t get far in filling out your core team without a competitive package of equity-based compensation. In other words, you’ll very likely need to offer stock options.
And therein lies a challenge: How can a young, private company offer common stock options if it doesn’t yet have a share price for its common stock? The answer, if you don’t want to get in trouble with the Internal Revenue Service, is something called a 409A valuation. And since we think staying on friendly terms with the IRS is a great idea, we’re here to walk you through everything a startup founder needs to know about 409A valuations—from what they are to how they’re actually calculated.
- What is a 409A valuation?
- Is a 409A valuation required for an early-stage startup?
- When do I need a 409A valuation?
- How do I choose the right 409A valuation firm?
- What is the process of getting a 409A valuation?
- How is my company’s 409A valuation calculated?
What is a 409A valuation?
A 409A valuation is an independent, unbiased appraisal of how much a private company’s common stock is worth. A 409A valuation sets out to determine the fair market value (FMV) of a company’s stock; in other words, it seeks to answer how much a share of that stock would go for on the open market. The FMV is then used to determine the price of stock options offered to employees.
Why is all this necessary? The short answer is that you can’t really offer an enticing equity package if you don’t know what a share of your company’s stock is worth. Not only is that confusing for a prospective employee, but the IRS doesn’t like it.
And that’s where the longer answer begins, because the IRS has a keen interest in making sure that companies value themselves as accurately as possible. A company that values itself too low could be trying to hide taxable income, and a company that values itself too high could be misleading potential investors. Better to have an independent appraisal that dissuades founders and executives from mispricing their company’s equity in the name of exploiting loopholes in the tax code, right?
Why is it called a 409A valuation?
Speaking of the tax code, the 409A valuation gets its name from Internal Revenue Section 409A, which was added to the Internal Revenue Code as part of the American Jobs Creation Act of 2004.
Passed in part as a response to the Enron accounting scandal of 2001, IRC 409A closed some loopholes in how stock options are taxed. It disallows stock options from being considered as tax-deferred compensation unless the option strike price equals the current value of the stock.
Is a 409A valuation required for an early-stage startup?
In short, yes. Any private company—a group that generally includes early-stage companies—that wants to issue shares to its employees must have a price attached to those shares. And in order to price shares in a way that’s accurate and acceptable to the IRS, a 409A valuation is required.
This is where public companies have it a bit easier. Public companies typically don’t have to worry about 409A valuations, because they already know the fair market value of their common stock—it’s the current stock price.
Pre-IPO private companies, however, need to put in a bit more legwork to figure out the fair market value of their common shares. The plus side is that the IRS offers “safe harbor” to private companies that conduct their 409A valuation according to certain valuation methods.
409A safe harbor: Putting the burden of proof on the IRS
There are real, tangible benefits to achieving what’s known as 409A “safe harbor.” As its name implies, safe harbor status means that a private company is safe from the IRS questioning its valuation as reasonable and valid. If you have safe harbor and the IRS decides to label your valuation as unreasonable, the burden of proof is on them and not you.
This is important! Safe harbor status allows you to structure any stock option grant to an employee as a tax-free event, which is basically what needs to happen if you want to offer a competitive equity package.
There are different methods to go about obtaining safe harbor status, but generally speaking, the easiest method is to work with a qualified, independent, third-party appraiser on your 409A valuation. It can be extremely difficult to obtain safe harbor using any other methodology, so chances are that you’ll need to find a valuation provider you trust to conduct a thorough, accurate, and comprehensive independent valuation.
When do I need a 409A valuation?
You will need to start thinking about a 409A valuation as soon as you decide that you want to offer stock options to your employees. The 409A valuation is an absolutely essential step to take before you even mention the words “stock options” to your employees, so we recommend getting a head start on the process by identifying an outside appraiser you trust to help with your valuation.
In many cases, a company will complete its initial 409A valuation at the time of its first financing round. So if you have a Series A coming up, now is the time to get the ball rolling. It can take several weeks or even months to identify the right appraiser and collect all the data and documentation you need, which makes a head start even more advantageous.
How often do I need to complete a 409A valuation?
An early-stage startup will typically be granted safe-harbor status for 12 months following its initial 409A valuation. That means you should expect to go through the 409A process again after the first 12 months, and again after that. In other words, you’ll have plenty of time to grow comfortable with the ins and outs of 409A valuation. (Don’t get too excited.)
In some cases, your company may be expected to complete a 409A valuation before the 12-month period is up. If your company has a new financing round or any other type of event that may demand an updated valuation, you’ll generally be expected to complete a 409A. So, the general rule is: a new 409A is required after 12 months or whenever a material event changes your valuation—whichever comes first.
How do I choose the right 409A valuation firm?
Take your time selecting your 409A valuation firm. You’ll want to find a provider you’re comfortable with, and one with a track record you can trust. Here are some general tips to guide you along the way:
- Focus on your field. Consider talking to candidates who already have experience in your company’s field. If you run a biotech startup, you may want to work with a provider who understands the specifics of your industry, versus a firm that’s only ever worked with online sales companies.
- Company size and location matter, too. If you lead a tech startup in San Francisco, you likely want to find a firm that has experience providing valuation services to companies in your local market. Similarly, it helps to work with a firm that understands the unique challenges faced by companies at your size and stage of growth.
- Complexity counts. Not all companies are created equal, but we didn’t have to tell you that. When shopping around for a 409A valuation firm, look into the complexity of valuations they’ve worked on in the past. A firm that has experience compiling 409A valuation reports for late-stage startups, for example, will likely have gone through the gauntlet of complexity—and thus may give you some extra peace of mind.
How is my company’s 409A valuation calculated?
Calculating the fair market value of a company’s stock isn’t always a straightforward process of crunching the numbers. In nearly every case, the firm you work with will take into account quantitative data (such as your company’s cap table, cash flow, and past financial statements) as well as qualitative data (such as your company’s relative maturity, growth stage, intangible assets, and financial projections based on comparisons with similar companies).
There are two general steps involved in calculating the FMV of your company’s stock:
- Value the company itself. First, you (or, more likely, the firm you’re working with) will need to figure out the value of the company. If you’ve recently completed a fundraising round, the business valuation set during that round should serve as a good benchmark. But there are other ways of estimating your company’s valuation, which can be more complex.
- Value the company’s common stock. After determining your enterprise value, that value needs to be allocated across your capitalization table. Once it’s divided up between all the types of equity in your cap table, you should be able to get the fair market value of a single share of common stock.
It’s important to note that the specific share value that emerges from this calculation may also include other factors, such as a discount for the fact that the shares are illiquid and can’t actually be sold on the open market at present. This complexity is exactly why it’s probably a good idea to work with a seasoned firm versus giving it a go yourself.
What are the benefits of a low 409A valuation?
There is a commonly held perception out there that the lower the 409A valuation, the better. This makes sense. Being able to grant stock options with a low (or relatively low) exercise price is good for attracting talent—especially talent that wants to grow with you into the future.
A couple of points on that:
One: This may matter less than you think. If you believe in your company and its ability to grow exponentially in the coming years, then the difference between a few cents in your current stock valuation will likely not matter all that much in the long run.
Two: The IRS generally does not appreciate cuteness of any kind when it comes to 409A valuations (it has the penalties to show for it). Obtaining safe-harbor status is very probably more important than squeezing the lowest possible valuation you can out of this process, so proceed accordingly.
While a 409A valuation may seem like a pain, it’s really a time to reflect on how far your company has come (and how far it still has to go). Every successful founder has to go through this 409A valuation process at some point or another, so think of it as a rite of passage and be sure to take it seriously. Oftentimes, the worst mistake you can make is thinking you can do it yourself or rushing your way through it because you’re focused on other aspects of your business.
The good news is that Pulley is here to help. If you want to learn more about our cap table platform for growing startups, schedule time with our cap table experts to get started today.