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Demystifying 409A Valuations: What are they and do you need one?

February 23rd, 2022   —   Charlie Ross

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If you’re a company planning to offer equity to anyone in the US, then it’s likely you’re going to need a 409A Valuation. Yep, that's right - even if your company is based outside the US, if you make an equity grant to anyone in the US, you'll need a 409a Valuation.

Start-up Founders & CFOs are fast realising how early stage 409A valuations completed by quick cookie cutter approach often result in inflated option prices and disgruntled employees. Naturally, a 409A valuation has to be more than just compliant; it has to be fair for your employees.

So, what is a 409A Valuation?

IRS Section 409A Valuations (409A Valuations) are an independent assessment of the fair market value of a private company. A 409A Valuation will determine how much it costs to buy stock in your company. Put another way, a 409A Valuation sets the Strike Price any option-holders must later pay to gain ownership of their stock.

You need a 409A Valuation if you plan to offer equity to employees. You might already have completed a valuation but unless it’s compliant with the 409A tax rules, recipients of stock won’t be eligible for tax concessions. So make sure the 409A valuation is completed before you issue your first common stock options.

A (tiny) history lesson

Equity loopholes were endless prior to the 2001 Enron scandal which prompted regulators to introduce the Section 409A legislation in 2005, which became effective in 2009. The legislation provides a framework for private companies to value themselves. By engaging an independent third party valuer, a “safe harbor” is created, meaning the IRS deems the valuation “reasonable”.

Setting a price for stock options before the advent of 409A regulations was thumb-rule driven, an inconsequential 10-minute exercise where it was often agreed at about 5%-10% of the latest preferred round. The need to conduct independent third-party valuation under 409A provisions changed this approach. Albeit, significantly burdening the cash-conscious start-ups.

Valuation as a discipline requires its practitioners to indulge in both art and science to form a judgment.  However, of late, pricing pressure has pushed several firms to gravitate quite heavily towards a template-driven, cookie-cutter approach to using the statistical Option-Pricing model in 409A valuations. While much lower fees, quick turnaround for 409A valuations seem good news for start-ups, several CFOs and law firms have explicitly expressed concerns over common stock being priced as high as 25%-35% of preferred issue price for Series A companies, which is a bad outcome for startups, investors and team members with equity.

But beware: if your company has not properly applied the 409A rules and isn’t valued correctly, the IRS might slap you with penalties. And employees and shareholders are the ones left to foot the bill (more in this later).

When should you get a 409A Valuation?

The answer is actually pretty straightforward:

  1. Before you issue your first common stock options
  2. After raising a round of capital
  3. Once every 12 months (or after a material event, i.e. a capital raise) OR
  4. If you’re approaching an IPO, merger, or acquisition

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What’s the deal with penalties?

If you don’t conduct a 409A valuation, there may be a high price to pay.

If a valuation isn’t conducted using one of the approved methods under the legislation, you could fall outside of the 409A safe harbor and penalties might apply, including:

  • All deferred compensation from the current and preceding years becomes taxable immediately
  • Accrued interest on the revised taxable amount
  • An additional tax of 20 percent on all deferred compensation

Whilst most startups aren’t likely to be audited by the IRS, if you start approaching a significant exit event like an IPO, it becomes a much more realistic prospect and it will be your employees and shareholders who end up out of pocket.

How do you know if your 409A is prepared correctly?

First of all, it’s important to engage a valuer that understands startups.

If a valuation expert applies the plain vanilla Option Pricing model (discussed up top) the results for common stock FMV can often vary between 30% to 35%. However, if a few pertinent questions are asked to dive deeper, true risk-profiles (and resulting valuations) can be identified. These questions include:

  • How much total funding an average successful start-up raises before exit in a biotechnology space compared to a company in SaaS business?
  • What is the median number of years an average successful start-up takes before seeing exit across different industry verticals? How exit patterns have changed?
  • What is the time-horizon of Series A companies to raise the next round of funding across different verticals?  What is the successful follow-on investment rate (to Series B)?
  • What is the typical cash-burn rate for start-ups in different industry verticals for Series A stage companies

A well-thought hybrid valuation model, which uses multiple scenarios of success and failure built on key milestones of dynamic business probabilities, can help better capture the impact of several key risks and result in a common stock value that more appropriately reflects the risk exposure of an investor.

While such hybrid models do increase the subjectivity in the valuation process, it’s better to be vaguely right than precisely wrong.

The real skill of the valuation analysts is to weigh in their research and report writing skills to craft the thesis in valuation reports to keep the common stock value rightfully low, convincing enough for companies, employees as well as auditors.

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This blog is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.

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