1. What is a 409A Valuation?
A 409A valuation, also called a Fair market value (FMV) valuation, is a process used to determine the fair market value of a private company’s common stock. For a privately held company, the 409A valuation is the sole manner to grant options on a tax-free basis to employees.
Conducted to comply with Section 409A of the Internal Revenue Code (IRC), it regulates the taxation of nonqualified deferred compensation. Independent valuation experts employ recognized methodologies to assess the company’s value based on financial performance, market conditions, and comparable data. The valuation report helps ensure compliance with tax regulations and establishes a defensible value for stock options, equity grants, and other forms of compensation.
2. Why Do Business & Startups Need a 409A Valuation?
It is important to find out properly if your company needs a 409A valuation.
When starting a company, with limited cash flows, equity can remain to be the perfect incentive to keep talent with them, while not letting go of much-needed cash flow in the form of salaries.
Equity-based or deferred compensation allows firms to provide fair compensation, without using cash. Equity based compensation also plays a vital role in aligning the interests of employees and employers and incentivizes all parties to work towards the betterment of the firm.
However, a problem that comes up is how to give employees a part of the firm when unsure about its actual worth? Here comes in the 409A.
409A helps govern deferred compensation and includes rules one must comply with to determine the fair market value of common stock.
In addition, the 409A sets the exercise price of stock options and other equity awards, however, the valuation must be done by a qualified appraiser and based on a reasonable valuation methodology.
3. When Do You Need a 409A Valuation?
Typically, a company redoes their 409A valuation every 12 months or so to maintain a safe harbor value. Safe harbor value refers to a valuation range within which the fair market value of the company’s common stock can be deemed to be reasonable.
If the firm’s 409A valuation falls within the safe harbor range, there is a level of protection that the firm has against potential IRS challenges or penalties.
Usually, a firm must redo the valuation when:
- A significant event occurs for the company, such as a new business model is adopted or there are changes made to the financing.
- The company is set to approach a new IPO or M&A
- The company wants to issue new stocks, usually common.
- Issuance of RSUs or restricted stock units, at time of grant.
It is important to note that certain types of retirement plans may also call for 409A valuations, if they involve employer stock, as they might need the valuation to comply with the suitable tax regulations.
4. What Factors Influence Your 409A Valuation?
Some of the 8 key factors affecting the 409A valuation are:
- Financial Performance: The financial health and performance of the company plays a crucial role. Factors such as revenue growth, profitability, cash flow and financial projections influence the valuation. Historical financial statements and forecasts are analyzed to assess the company’s potential.
- Industry and Market Conditions: The industry in which the company operates and the overall market conditions can impact the valuation. Factors like market size, competition, growth prospects and regulatory environment are considered. If the industry is thriving and the company has a unique position, it can positively impact the valuation.
- Intellectual property and Assets: The presence of valuable intellectual property assets, patents and trademarks or copyrights can contribute to a higher valuation. Proprietary technology or products that provide a competitive advantage can be significant drivers of value.
- Management Team: The expertise and track record of the management team can prove to be essential for a good valuation. Experience and capable leadership that has a successful history of managing and growing businesses can boost the valuation.
- Growth Potential: Investors consider the growth potential of the company, both in terms of market expansion and product innovation. Factors such as scalability, customer base, product pipeline and expansion plans are assessed to determine future prospects.
- Comparable Company Analysis: Valuation experts may also compare the company to similar businesses in the market to understand its relative value. Factors such as size, growth rates, profitability, and market multiples of comparable companies are considered.
- Capital Structure: The company's capital structure, including debt, equity, and any outstanding preferred stock, can influence the valuation. Dilutive securities or complex capital structures may require additional adjustments.
- Market Sentiment and Risk: The overall market sentiment and investor appetite for similar companies or sectors can affect the valuation. Additionally, the risk profile of the company, including factors like competition, regulatory risks, and market volatility, is taken into account.
5. How Long Does the 409A Valuation Process Take?
The duration of the 409A valuation process can vary depending on several factors, though if the necessary data is ready, it can take about two weeks to get the final draft.
Here are 5 factors that can influence the timeline:
- Company Complexity: The complexity of the company's capital structure, financials, and operations can impact the time required for the valuation. If the company has multiple classes of stock, intricate securities, or complex financial arrangements, it may take more time to analyze and evaluate.
- Availability of Information: The availability and accessibility of necessary information also play a role. If the company can readily provide all the required financial statements, forecasts, market data, and other relevant documents, it can expedite the process. Delays can occur if there are challenges in obtaining or verifying the information.
- External Valuation Firm: Engaging an external valuation firm to perform the 409A valuation introduces an additional variable. The availability and workload of the valuation firm, as well as the efficiency of their processes, can influence the timeline.
- Internal Processes: Internal processes within the company, such as gathering information, coordinating with stakeholders, and obtaining necessary approvals, can impact the overall timeline. Efficient coordination and cooperation among various parties involved can help expedite the process.
- Market Conditions: Market conditions and external factors beyond the company's control can also influence the timeline. For example, if there are significant market disruptions or changes that require additional analysis or adjustments, it can extend the valuation process.
A typical timeline would involve data collection, valuation modeling, draft scheduling, and management review, post which the company is to obtain the Board’s approval and can proceed with granting options.
6. What are the major things you look at when you calculate a 409A valuation?
8 things to remember when you calculate a 409A valuation:
- Basic information of your company, including the sector or industry, company historicals, financials and debt projections. This also includes any important articles to the company that might have been amended.
- Most recent cap table, if the company has raised any capital.
- The number of options the company expects to issue in the next financial year.
- Most comparable companies, as this allows the provider to look at volatility in comparison to the public companies and general market.
- Timing expectations, especially for potential liquidity events such as IPO or M&A
- Events that happened since past 409A valuation that could affect new pricing.
- The company pitch deck could also prove to be useful.
- Share purchase agreement if available.
The provider also takes into consideration the cost of preferred shares and would be applying a discount to common stock to adjust for their illiquidity. The discount rate depends on how close the firm is to a liquidity event.
7. How to best obtain a 409A valuation?
One thing to keep in mind is the best way to ensure that the 409A valuation is done correctly is to have an independent and rightly equipped provider to conduct the necessary analysis. This does not solely mean having the right credentials, but also looking at whether or not the provider has previous experience in your sector, industry and stage.
This is like having a tax provider for your personal income taxes: you look not just for a certified CPA, but also someone who has experience with tax filing for people similar to you, giving you the opportunity to leverage their experience.
Additionally, if your provider has tied with major audit firms such as the Big 4 accounting firms, Deloitte, PwC, KPMG, and E&Y, or regional firms, it can be a good indicator of their works, deeming it respectable and defensible by experts in the audit industry.
Understanding 409A valuations can be tedious, with all the jargon mixed with minute details that can be easy to graze over. To have a clearer understanding of inputs, processes and next steps regarding the valuation process, speak with our experts and receive the final report within two weeks.
