A startup founder’s guide to 409A valuations
At their core, startups are melting pots of promising ideas, big ambitions, and hard work. But these alone aren’t enough to fuel and sustain a startup’s development. Founders must also think about hiring the right people in order to make their mission a reality. However, this is easier said than done, given how thinly a startup’s resources can be stretched.
This is where stock options enter the picture. Used as an attractive form of compensation for existing employees and potential hires, offering equity is a sure way to attract and retain talent. But before a startup can go down this route, they’ll need to put a price tag on their shares.
409A valuations step in here: they are both a regulatory requirement and a way of assessing the price of a startup’s shares. Moreover, they also represent a major hurdle all startups must overcome. To guide founders through the process, we’ll walk you through the A to Zs of 409A valuations from definition to calculation.
What are 409A valuations?
A 409A valuation is an appraisal of your startup conducted by an independent, third-party appraiser (e.g., through a valuation provider like Aranca). This process determines the fair market value (FMV) of a startup’s common stock and is used to calculate the strike price (also referred to as the exercise price), which establishes the price at which a startup’s shares can either be bought or sold.
That said, a 409A valuation is more than just an appraisal. It is also a strict regulatory requirement established under Section 409A of the IRS’s Internal Revenue Code (IRC) which startups must comply with to avoid hefty penalties. In the eyes of the law, the valuation serves two purposes:
- It calculates the price of a startup’s share, ensuring accuracy for its prescribed price.
- It keeps founders and employees protected from inequitable situations.
Why do startups need a 409A valuation?
Startups need 409A valuations for several reasons: if they want to grant stock options to employees (e.g., under equity compensation plans), wish to avoid legal penalties, or are currently trying to raise funding
Compliance
Staying on the right side of the law is crucial, especially for early-stage startups with scarce financial resources. Though Section 409A itself goes well beyond obtaining a 409A valuation, it is one of the most important requirements which must be complied with to avoid significant penalties and additional tax burdens on employees and founders.
Fairness
409A valuations, because they’re used to determine the FMV and strike price, help protect employees from potential exploitation and ensure that everyone gets a fair deal in terms of stock options. Likewise, founders also benefit from this as granted stock options aren’t sold or given at too low of a price or at a too high quantity.
Protection
A properly conducted 409A valuation can confer certain legal protections on startups. For example, if your startup has used a qualified and independent valuation provider to produce your 409A valuation and has taken reasonable steps to ensure its accuracy, your 409A report would generally be granted safe harbor status. This essentially means that your valuation is presumed to be valid by the IRS. Though this could be achieved without an external provider, the process would be far more lengthy and complicated.
Incentivization
Incentivizing employees with stock options is a powerful way to attract top talent and retain existing employees. This is often a startup’s preferred tool, especially during earlier stages as competing with more established companies is difficult when it comes to attracting skilled employees. Additionally, by providing employees with a tangible stake in the company, the startup’s success becomes tied up with the employees, fostering a sense of collective ownership that can lead to more productive outcomes.
What do 409A valuations require?
Whether a startup decides to do a 409A valuation in-house or through an independent appraiser, the information and materials required for the process are generally the same.
While the specific documentation and information required will vary based on the startup’s situation and valuator of choice, startups are usually required to produce the following as part of the 409A valuation process:
Consequences of not getting a proper 409A valuation
The imposed penalties for non-compliance with IRC Section 409A are both severe and entirely non-negotiable. They are capable of overwhelming startups of all sizes and stages and have led to the downfall of many. Neither founder nor employee is safe when it comes to non-compliance, as potential consequences include:
Repayment and additional taxation
If a startup’s 409A valuation is found to be non-compliant, all deferred compensation (i.e., all compensation from bonuses, salaries, and options that have not yet been received or taxed upon) from that year and years prior will become immediately taxable. This is also subject to up to an additional 20% tax, thus increasing the tax liability of all affected employees and shareholders.
Reputational damage
A startup’s reputation is its lifeblood. Non-compliant 409As are synonymous with the improper internal management of a startup’s finances and ability to comply with regulatory requirements. This risks sending negative signals to investors, potential hires, and even customers who may feel uncomfortable working with your startup.
Common 409A valuation mistakes
Getting a 409A valuation and fully understanding its finer details can be tricky, often taking founders years to fully work it out. Along the way, some of the most common mistakes made by startups include:
Forgetting to update the valuation
409A valuations are only valid for 12 months or until a material event takes place which directly involves your startup, such as mergers or going through financing rounds. This is also referred to as a 409A refresh.
Unfortunately, it is common for startups to forget that valuations need to be done annually or after going through a significant event. This issue must be actively avoided as an invalid 409A valuation would expose the startup to a host of penalties and fines and rescind any existing safe harbor protections.
Not engaging a qualified and independent 409A appraiser
While disclosing your startup’s 409A report with your employees is not a prescribed legal requirement, choosing to be transparent about it can prove beneficial on two fronts.
First, more transparent and open workplaces foster organizational trust, which can demonstrate your commitment to fairness and openness, leading to better productivity. And second, employees would be better informed of their stock options and equity compensation plans, which can minimize confusion and potential disputes down the road.
Manipulating the 409A valuation
Many newer and inexperienced startup founders tend to directly conflate the findings of a 409A valuation with how much their startup is worth (e.g., trying to get a lower strike price). Not only is this an inaccurate assumption, but it drives some founders to manipulate the 409A’s findings in order to get their desired result. This is both unethical and illegal.
409As require valuations to be done in good faith, as completely and accurately as possible, guided by established practices. If it comes to light that a startup has done otherwise, it wouldn’t be an exaggeration to say that the impending penalties could bankrupt both founders and employees.
How to get a 409A valuation
In the majority of cases, 409A valuations are performed by independent appraisers as opposed to the startup itself (i.e., in-house). While this is the most popular and recommended method, it is technically possible to get a 409A valuation through other means:
Option 1: Doing it yourself
Doing a 409A yourself may seem appealing due to the money saved — especially for smaller, early stage startups whose financial records aren’t convoluted yet. However, opting to do your own valuation in-house nowadays is rare and unadvised as 409A valuations are complex affairs. The potential downsides of making a mistake far outweigh any upsides in doing it yourself:
Option 2: Using online tools
Startups can also use software to generate their 409A valuation report. Even so, while this may seem preferable compared to doing it entirely by yourself, it suffers from similar issues to the first option:
Option 3: Engaging a qualified, third-party valuator
Seeking the services of an independent appraiser is the best way to ensure your 409A valuation is as accurate as possible and able to protect both you and your employees from regulatory disputes:
Evaluating your valuator
Simply knowing that hiring an independent appraiser is the preferred method is only half the battle. The other half comes in knowing what to look for in potential valuators. As a general rule of thumb, you should always consider the following questions:
“Do they have a solid track record?”
Make sure your valuator of choice has a track record of success in providing accurate and timely valuations. With so much at stake, founders cannot afford to hire valuators who lack demonstrated expertise. Consider checking G2.com for relevant reviews or going through companies like LTSE Equity who themselves go through the process of thoroughly vetting their valuators.
“Do they have relevant experience?”
No two 409A valuations are truly the same. They all depend on a startup’s unique circumstances which is why you should ensure that your valuator of choice has relevant, industry-specific experience working with other startups like yours. For instance, if your startup is in the ed-tech sector, look for valuators with specific domain knowledge who’ve worked with identical companies in the past instead of choosing a more generalist valuator.
“Can I afford their services?”
The total cost of a 409A valuation depends on a staggeringly long list of factors. These include the size of the startup, its stage, ownership structure, the industry, and the experience of the valuator, amongst other things. 40A valuation costs can go from hundreds to thousands of dollars while pricing isn’t always transparent. Make sure you realistically assess your financial position and schedule consultations with potential valuators before making a plunge.
How 409A valuations are commonly calculated
While there is no single, universally imposed method that is required to calculate 409A valuations, several common methodologies have emerged which are commonly used by valuators — sometimes together — depending on the specifics of a startup.
The market approach
Ideal for smaller, early-stage startups, the market approach is often used when valuators find it challenging to accurately assess how well the startup might perform in the short and long run. By closely examining the performance of other public companies that share similar characteristics and are in the same industry, the startup being valuated is compared to them and the subsequent findings are then used to inform the 409A report.
The income approach
Often used for startups who have achieved a degree of success in establishing their presence and performing steadily in terms of financial performance, the income approach values a startup by assuming that value comes from projecting the future performance of the startup and discounting those findings from its present value. In other words, this approach assumes that how much a startup is worth is directly related to the startup’s ability to generate returns in the future.
The asset approach
Compared to the other two methodologies, the asset approach is relatively simple and is usually used for very early-stage startups that are still pre-revenue. By examining the startup’s assets and liabilities, the asset approach assumes that the value of a startup can be calculated by substrating the value of its assets from its liabilities.
The 3 approaches, summarized
Market approach -> Compares the startup to similar public companies.
Income approach -> Focuses on the startup’s future performance.
Asset approach -> Value is derived from a startup’s assets and liabilities.
Getting a 409A valuation is one of the most important things a startup cannot afford to get wrong. That's why it's important that it is conducted by an independent, third-party appraiser and is not only an appraisal but also a strict regulatory requirement under the IRS's Section 409A. By properly complying with the 409A valuation requirement, startups can avoid hefty penalties and create a foundation of fairness and transparency in their equity compensation plans.
Ready to learn more about listing on the LTSE Exchange?
