409A Valuation: Everything You Need to Know

In this article, we will explain everything you need to know about 409A valuation, including its definition, purpose, methods, costs, benefits, and pitfalls. We will also show you how Knowcraft Analytics can help you with your clients’ 409A valuation needs.

What is a 409A Valuation?

A 409A valuation involves determining the fair market value of a company’s common stock for the purpose of complying with Section 409A of the Internal Revenue Code (“IRC”) in the United States. This section was introduced to address concerns related to the proper reporting and taxation of deferred compensation, especially in the context of non-qualified deferred compensation plans. As a matter of fact, companies situated even outside the US, planning to issue options to its US taxpaying employees, need to engage an independent specialist and establish the fair market value of the common shares.

409A Valuation vs. Post-Money or Venture Capital Valuation: Key Differences

A 409A valuation is a formal valuation of a private company’s common stock, performed by an independent third-party appraiser. The main purpose of a 409A valuation is to determine the fair market value (FMV) of the common stock, which is used to set the strike price of the stock options granted to employees and other service providers.

A post-money valuation, on the other hand, is the market value negotiated between the entrepreneur or the company and the venture capitalist(s) interested in investing in the company.

The two types of valuations are different in several ways:

Methods: A 409A valuation typically uses one or more of the following methods: income, market, and asset. These methods are based on the company’s historical and projected financial performance, comparable trading companies and past transactions. A venture valuation is typically driven by business, market and investor-specific factors.
Underlying: The end result of a 409A valuation is determining the value of common stock. A venture valuation, typically, is done for potential investment in preferred stock.
Treatment of different classes: A private company generally has different classes of stock. A 409A would treat these classes separately based on their rights and preferences in the distribution stack. For example, a common stock holder would typically not get his/her money back until the preferred stock holders have received their returns. A post-money valuation, on the other hand, treats all classes of stock the same i.e., on a fully diluted basis.

What is IRC Section 409A?

IRC Section 409A is a tax code that regulates the taxation of deferred compensation, which is any compensation that is earned in one year but paid in a later year. Deferred compensation includes stock options, restricted stock units, performance bonuses, severance payments, and other forms of nonqualified deferred compensation.

The main implication of IRC Section 409A for startups and employees is that they have to comply with the rules and requirements of the tax code, or else face severe penalties and consequences. Some of the key rules and requirements are:

The stock options granted to employees and other service providers must have a strike price that is equal to or greater than the FMV of the common stock on the date of grant. This is where the 409A valuation comes in, as it provides an objective and reliable way to determine the FMV of the common stock.
The stock options must be exercised within a certain time frame after the employee or service provider leaves the company, or else they will be forfeited. The time frame varies depending on the reason for leaving, such as termination, retirement, disability, or death.
The stock options must not be modified, extended, or exchanged for other forms of compensation, unless the modification, extension, or exchange complies with the 409A rules and does not result in a deferral of income or a change in the time or form of payment.

How much does a 409A cost?

The cost of a 409A valuation depends on several factors, such as:

The size and stage of the company: A larger and more mature company usually has more complex capitalization structure, detailed financial data, and diverse business operations, which require more time and effort to analyze and appraise. A smaller and less established company usually has simpler and more straightforward capitalization structure, financial data, and business activities, which require less time and effort to examine and evaluate.
The quality and reputation of the appraiser: A more reputable and experienced appraiser usually charges more than a lesser known or experienced appraiser.
Frequency: The more frequent or recurring valuations are charged lower due to synergies obtained from existing valuations.
Timing: 409A valuations with standard timelines command lower prices than the 409A valuations with expedited timelines.

What is a 409A refresh?

A 409A refresh is an update or a revision of a previous 409A valuation, performed by the same or a different appraiser. The main benefit of a 409A refresh is that it ensures that the FMV of the common stock reflects the current and accurate value of the company, which may have changed since the last valuation due to various internal and external factors.

A 409A refresh is required when and as often as there is a material change in the company’s circumstances that affects the value of the common stock, such as:

A new funding round, a merger, or a sale of the company
A significant increase or decrease in the company’s revenue, profitability, or cash flows
Events like stock-split, recapitalization, etc.
Steps towards IPO such as engaging investment bankers for an IPO.
A major product launch, customer acquisition, or market expansion
A substantial change in the company’s business strategy, operations, or management
A notable shift in the industry trends, competitive dynamics, or regulatory environment

What is 409A safe harbor?

409A safe harbor is a provision in the IRC Section 409A that grants a presumption of reasonableness to a 409A valuation, meaning that the IRS will not challenge or question the FMV of the common stock determined by the valuation, unless there is clear and convincing evidence to the contrary. 409A safe harbor is an advantage for startups and employees, as it reduces the risk and uncertainty of 409A audits, disputes, and penalties.

To qualify for 409A safe harbor, a 409A valuation must meet the following criteria and conditions:

The valuation must be performed by a qualified independent appraiser, who has significant experience, education, and credentials in performing valuations, and who is not affiliated with or influenced by the company, the investors, or the employees.
The valuation must be based on reasonable and consistent methods, assumptions, and data, that reflect objective and factual information about the company, the industry, and the market.
The valuation must be documented and supported by a comprehensive and detailed valuation report, that explains the rationale and calculations behind the valuation, and that complies with professional and ethical standards of the appraisal industry.
The valuation must be updated and refreshed at least once every 12 months, or more frequently if there is a material change in the company’s circumstances, that affect the value of the common stock.

What do I need for a 409A Valuation?

To obtain a 409A valuation, a company needs to provide the following documents and information to the appraiser. Note that these reflect the requirement on a broader level, and may change from case-to-case.

Financial statements: The company’s income statements, balance sheets, and cash flow statements for at least past three years, or since inception if the company is less than three years old. These statements should show the company’s revenue, expenses, assets, liabilities, and equity.
Financial projections: The company’s financial projections for the next five years, or until breakeven if the company is not profitable yet. These projections should show the company’s expected revenue, expenses, cash flow, and growth rate.
Capitalization table & Articles: The company’s capitalization table, which shows the ownership structure and distribution of the company’s equity, including common stock, preferred stock, stock options, warrants, and convertible securities. The cap table should also show the exercise prices, vesting schedules, and expiration dates of the stock options and other equity instruments. Further, the articles of incorporation reflecting rights and preferences of various securities are required to allocate equity value among various securities.
Business plan: The company’s business plan, which describes the company’s mission, vision, goals, strategies, products, services, customers, markets, competitors, opportunities, challenges, risks, and milestones.
Valuation history: The company’s valuation history, which shows the previous valuations of the company, including the dates, methods, assumptions, and results of the valuations. The valuation history should also show the previous funding rounds, secondary transactions, mergers, acquisitions, or sale of the company, including the dates, terms, and conditions of the transactions.
Other information: Any other information that may be relevant or useful for the appraiser, such as industry reports, market research, customer feedback, product reviews, company’s growth and risk factors, press releases, news articles, awards, recognitions, patents, trademarks, licenses, contracts, agreements, or lawsuits.

How do LLCs handle valuations?

An LLC, or a limited liability company, is a type of business entity that combines the features and benefits of a corporation and a partnership, such as limited liability, pass-through taxation, and flexible management and ownership. An LLC is different from a corporation in several ways, such as:

An LLC does not issue shares of stock, but instead issues units of membership interest, which represent the ownership and rights of the members of the LLC.
An LLC does not have a board of directors, but instead has one or more managers, who may or may not be members of the LLC, and who are responsible for the management and operation of the LLC.
An LLC does not have a fixed capital structure, but instead has an operating agreement, which defines the terms and conditions of the LLC, such as the allocation of profits and losses, the distribution of cash and assets, the admission and withdrawal of members, and the valuation and transfer of membership interests.

Knowcraft Analytics provides audit-defensible 409A valuation

Knowcraft Analytics is a leading provider of 409A valuations, and offers high-quality and audit-defensible 409A valuations, performed by qualified and independent appraisers, using reasonable and consistent methods, assumptions, and data, documented and supported by comprehensive and detailed valuation reports.

To learn more about Knowcraft Analytics, please visit our website at www.knowcraftanalytics.com.

FAQs

Here are some frequently asked questions and answers about 409A valuations:

What is a 409A valuation?
A 409A valuation is a formal valuation of a private company’s common stock, performed by an independent third-party appraiser, to determine the fair market value (FMV) of the common stock, which is used to set the strike price of the stock options granted to employees and other service providers.
Why do startups need a 409A valuation?
Startups need a 409A valuation to comply with the rules and requirements of IRC Section 409A, a tax code that regulates the taxation of deferred compensation, such as stock options, restricted stock units, performance bonuses, severance payments, and other forms of nonqualified deferred compensation. By obtaining a 409A valuation, startups can avoid the penalties and consequences of noncompliance, such as additional income tax, interest charge, state tax, and audit risk, for themselves and their employees.
How often do startups need a 409A valuation?
Startups need a 409A valuation at least once every 12 months, or more frequently if there is a material change in the company’s circumstances that affects the value of the common stock, such as a new funding round, a merger, or a sale of the company, a significant increase or decrease in the company’s revenue, profitability, or cash flow, a major product launch, customer acquisition, or market expansion, a substantial change in the company’s business strategy, operations, or management, or a notable shift in the industry trends, competitive dynamics, or regulatory environment.
How much does a 409A valuation cost?
The cost of a 409A valuation depends on several factors, such as the size and stage of the company, the frequency and timing of the valuation, and the quality and reputation of the appraiser.
How long does a 409A valuation take?
The time of a 409A valuation depends on several factors, such as the availability and complexity of the data, the method and assumptions used for the valuation, and the communication and cooperation between the company and the appraiser. The time of a 409A valuation can range from a few days to a few weeks, depending on the company and the appraiser. However, the average time of a 409A valuation is around 10 to 15 business days, according to industry surveys and reports.