If you own a startup and plan to offer your employees equity, a 409A valuation is essential. Below, we’re breaking down what a 409A valuation is, why it matters, and when and how your company can get one.
What is a 409A valuation and why do you need one?
A 409A valuation helps determine what your company is worth—more specifically, what a piece of ownership (or share of stock) in your company is worth. After all, you can’t give employees equity in your company before you establish the value of that equity. For publicly traded companies, the market dictates the stock price. But when you own a private company, you have to rely on other factors to determine the stock’s value.
That’s where a 409A valuation comes into play. A 409A valuation is a third-party assessment of the fair market value (FMV) of your company’s common stock, which is the type of stock generally given to founders and early-stage employees, unlike preferred stock that typically doesn’t have voting rights. The FMV—which determines the share price of the stock—is considered the value of the company, so it’s what your stock would be worth if it was available on the public market. While your FMV can change, the strike price (also referred to as the exercise price) won’t change—and is the purchase price for employee stock options when they are exercised after a vesting period. Those vested options can in turn be sold after a liquidity event (e.g., IPO or acquisition).
The Internal Revenue Service (IRS) created 409A valuations to ensure that private companies issuing equity to employees are setting fair prices for their stock. Using an independent provider to conduct an objective third-party valuation creates what’s called a safe harbor, which means the valuation report is considered reasonable by tax code standards, according to section 409A of the Internal Revenue Code (IRC).
Who should get a 409A valuation—and when?
If you fall into that category, it’s important to note that a valuation isn’t a one-time thing. To accurately reflect your company’s growth and changing value, you need to get a new valuation whenever your company goes through a material event—or every 12 months. A material event is anything that can influence the price of your company’s stock. Think: a merger, acquisition, initial public offering (IPO), or new round of venture capital.
To summarize, you should get a 409A valuation:
- Before you issue common stock
- Following a material event
- Every 12 months
The risk of not getting a valuation
If you don’t get a 409A valuation for your company when you need to, your common stock won’t be accurately priced. And if the IRS audits your startup and discovers that your stock isn’t priced right, you could be putting your company—and anyone who holds stock options in your company—at risk.
In addition to paying taxes on their stock options, stock option holders may have to pay a 20% federal penalty (20% of the value of their options) as well as any state penalties. Plus, you may have to answer questions from the Securities and Exchange Commission.
How does the valuation work?
There are three main valuation methods appraisers use to estimate your company’s enterprise value:
- Market approach: The market approach analyzes financial information from comparable public companies—taking into account their industries, sectors, revenue, and market size—to estimate your company’s worth. This methodology is best for early-stage companies that aren’t bringing in a lot of revenue yet. There are different types of market approaches that can be used, but the backsolve one is different from the others, because it can follow a fundraising event to estimate a company’s equity value based on that valuation round.
- Income approach: Drawing from your company’s cash flow and revenue growth, this approach forecasts your company’s future income to figure out its value. It’s a good option for startups that have a history of revenue and are nearing profitability.
- Asset approach: The asset approach adds up your company’s total assets )including tangible and intangible assets), then subtracts your liabilities to figure out its value. This method isn’t used as often as the other two, but it can be a helpful approach for companies that haven’t even started raising money yet.
How do you get a 409A valuation?
There are a few steps to getting a 409A valuation:
Step 1: Find an appraiser
You may be tempted to conduct a 409A valuation using valuation software or your internal financial team, but a DIY approach can lead to non-compliance errors and problems down the line. To increase your chances of securing a safe harbor, it’s best to hire a reputable 409A appraiser to conduct the independent valuation.
For an independent appraisal, finding the right valuation provider might require some research, but you have a few options for getting started:
- Consult your business accountant for advice.
- Reach out to your investors for guidance.
- Ask your network of professional contacts or fellow founders for recommendations.
Look for appraisers that have strong credentials and experience in providing valuation services for companies in similar industries, sectors, and growth stages as yours.
Step 2: Gather your documents
409A valuations require a lot of documentation to support the burden of proof. In addition to basic company details (like founder information, company size, and location), you’ll also usually need to provide:
- An up-to-date business plan
- Your company’s articles of incorporation
- Your cap table showing the breakdown of your company’s ownership
- Your most recent fundraising pitch deck (if applicable)
- Information about your industry and sector
- Financial statements, including your profit and loss statement, cash flow statement, and balance sheet
- Your plan for issuing stock options, including details about how many you plan to issue, when, and to whom
- An explanation of how recent events (like new funding) have affected your company
- A tentative timeline for upcoming events (like an IPO)
Step 3: Review and finalize the report
The complete 409A valuation process can take anywhere from a couple of weeks to a full month, depending on how much information you provide, how many questions you have, and how quickly your valuation firm can work.
Once you hire an appraiser, you’ll typically schedule a couple of kick-off calls to discuss and agree upon a valuation methodology. Then you’ll submit paperwork and answer any questions the firm has about your company. After the firm finishes the valuation, you’ll generally have an opportunity to review the information and ask questions. From there, the valuation firm will finalize the report and you’ll send it to your board of directors for approval.
If it’s approved, you can begin the process of granting stock options.
The importance of a 409A valuation
Regular 409A valuations are a crucial part of being a startup founder. If you want to issue stock options to your employees as deferred compensation, getting your company valued is critical to staying compliant with the IRS and ensuring your company’s equity is fair.