Understanding the real cost of 409A valuation

409A valuation is an important piece of the puzzle for startups and private companies issuing equity compensation to their teams.

Named after Section 409A of the Internal Revenue Code, this valuation determines the fair market value (FMV) of a company’s common stock. It sets the strike price, which is the predetermined price at which a stock option can be exercised or a stock can be bought or sold. It is important to note that setting a reasonable strike price for stock options is vital as it impacts employee returns, equity offerings, and recruiting efforts.

However, one of the primary concerns for many startups is the cost associated with obtaining a 409A valuation.

In this article, we will deep dive into the importance of a 409A valuation, the factors that influence its cost, and what companies can expect when budgeting for one.

First things first

Why startups need 409A valuations

409A valuation is essential for startups primarily for reasons related to compliance, employee incentives, and financial accuracy.

Mike Magnacca, CEO of 409.AI and formerly a valuation expert from a Big 4 accounting firm, observes that one of the most common mistakes in all his years working with startups is that many are unsure of the purpose of a 409A valuation.

Many businesses are unclear of the purpose of a 409A valuation. This is not a valuation to tell you how much your business would sell for or even what an investor should invest at, instead its focused on understanding the value of the common shares (not preferred shares). It's typically lower than what investors have valued your company at as it takes into account a discount for lack of marketability and it's focused on where your business is at today, not five years from now.
^{Mike Magnacca, Founder & CEO of 409.AI}

Understanding the importance of a 409A valuation allows us to justify the costs, so let's start with just that — here's why you need a 409A valuation:

Compliance with IRS regulations

As a startup, one of the most important things you want to get in order is compliance. The IRS mandates that private companies offering stock options to their employees must determine the fair market value (FMV) of their common stock. Regular updates to the valuation of a private company's common stock are crucial for compliance. Failure to comply can result in penalties, including fines and back taxes.

A certified 409A valuation provides a “safe harbor” that presumes the valuation is correct, offering legal protection in case of IRS audits. Audit firms play a crucial role in ensuring compliance and conducting due diligence. This protects the company from potential disputes and financial repercussions.

Fair employee compensation

Stock options are a significant part of compensation packages for many startups. Offering options at an accurate FMV ensures that employees receive fair value for their work, which is crucial for attracting and retaining top talent.

For early-stage companies, accurate 409A valuations are essential in offering equity to employees. Establishing fair market value in 409A valuations determines the exercise price for employee stock options, ensuring that employees are not over- or under-compensated, reducing the risk of future disputes regarding stock option pricing.

Facilitating investment and growth

Investors prefer companies that maintain regulatory compliance and financial accuracy. A 409A valuation demonstrates that the company is diligent in its financial practices, which can enhance investor confidence and facilitate future funding rounds.

An accurate 409A valuation also helps in realistic financial planning and forecasting, essential for strategic decision-making and growth planning.

Supporting strategic decisions

In events like mergers, acquisitions, or IPOs, having a recent and accurate 409A valuation is crucial. It ensures that the company’s worth is fairly represented, aiding in negotiations and transactions. Regular valuations provide insights into the company’s financial health and market value, supporting informed decision-making at the executive level.

Employee motivation

When employees understand that their stock options are valued fairly and regularly, it boosts morale and aligns their interests with the company’s success. Fairly valued stock options serve as a powerful motivation for employees to contribute to the company’s growth as their personal financial success is directly tied to the company’s performance.

Deep dive

Factors that influence the cost of 409A valuation

The cost of a 409A valuation report depends on several factors. Accurately estimating the company’s stock price through a 409A valuation is crucial to avoid tax penalties. As your company grows, the valuation costs can increase due to the expanding equity and the need to offer competitive returns to future hires.

The complexity of your company’s capital structure and financial projections often influences the 409A valuation cost as well. Here’s an estimation of the costs, depending on a startup’s growth stage:

Early-stage private companies and complexity

• Early-stage startups. For newly established startups with minimal financial history and simpler capital structures, the 409A valuation cost is generally lower. These valuations typically range from $2,500 to $5,000.
• Growing companies. As companies grow, their financial situations become more complex with multiple rounds of funding, varied revenue streams, and diverse ownership structures. Valuations for these companies typically range from $5,000 to $10,000.
• Late-stage startups and mature private companies. Companies nearing an initial public offering (IPO) or those with extensive financial and operational history may see costs upwards of $10,000 to $25,000. The increased complexity and the need for detailed analysis drive these higher costs.

It’s important to note that while this is the estimated range for 409A valuation firms and service providers, many contemporary startup experts have developed ways to streamline the process, lowering the costs to a more startup-friendly range.

“The good news is, while it used to be that these 409As are extremely expensive and complicated, there are cap table providers and firms now that have simpler and much more affordable solutions. With Cake, for example, you can just add-on a 409A valuation report into your subscription plan, it’s not that hard anymore!”
^{– Jason Atkins, Co-Founder at Cake}

Cake offers audit-proof valuation at a fixed rate of $1200 on top of your cap table subscription. Know more about Cake’s 409A valuations here.

Frequency of valuations

The IRS mandates that 409A valuations be performed at least once every 12 months or whenever a material event occurs, such as a new funding round or significant changes in the business model. In such a case, a 409A valuation update is required. Frequent valuations can lead to higher overall costs but ensure compliance and accurate stock pricing.

Geographic location

The cost of a 409A valuation can also vary depending on the geographic location of the valuation firm and/or the company. Firms based in major financial hubs like San Francisco or New York may charge premium rates compared to those in smaller markets. The higher cost of living and operating expenses in these cities contribute to the increased fees.

Depth of analysis

Basic valuations rely on standard methodologies and financial statements. They are less costly and suitable for simpler financial situations. Detailed valuations involve comprehensive financial modeling, market analysis, and scenario testing. These are necessary for companies with complex financial structures and significant growth trajectories, leading to higher costs.

Data availability and quality

The availability and quality of the company’s financial data can significantly impact the cost of a 409A valuation. Well-organized and readily available data can streamline the valuation process, reducing the time and effort required by the valuator. Conversely, incomplete or poorly organized data can lead to higher costs due to the additional time needed for data gathering and verification.

As always, we recommend consulting with professionals when preparing the business documents needed for 409A valuation before you begin apply. Having your cap table in Cake cuts the process in half as you can readily download your cap table information in a single click! Know more.

The Real cost of 409A valuation

How much does a 409A valuation cost?

We've talked about the actual cost of obtaining a 409A valuation report. and why it's important for startups to be meticulous about the process.

But now let’s talk about the higher price to pay if you fail to properly conduct a 409A valuation.

Inaccurate valuations can lead to many problems down the line, such as difficulty raising capital or creating major discrepancies between what shareholders expect to receive compared to what the company has valued. As mentioned earlier, failure to comply can result in penalties, including fines and back taxes.

When asked about the financial risks that come with incorrect 409A valuations, Mike Magnacca answers:

“There are a multitude of penalties a US business can incur with missing or incorrect 409A valuations, some of which include:

Tax implications for employees. Employees might face immediate tax liabilities on their stock options (ie. a large new tax owing amount), leaving employees in a very difficult position.

Monetary penalties. The IRS can impose fines that could be substantial, depending on the degree of non-compliance. In cases where the business hasn't proactively self-corrected its 409A valuations, and the error is noted by the IRS, penalties can be in the hundreds of thousands of dollars.

Legal and reputation risks. Beyond financial penalties, legal challenges and a damaged reputation can have long-term effects on your startup’s growth and ability to attract talent and investment.

It's important to spend the time to maintain compliance today to set your company up for success long term.”
^{– Mike Magnacca, CEO of 409.AI}

Matt Secrist from Taft Law also warms that it can be costly specifically for the stock option holders more than the company if you get your valuation wrong.

“The tricky thing with 409A is, unlike a lot of US and other countries' tax code provisions, the penalties are actually on the employee, the participant, not the company or the employer. Under 409A, if you violate those rules, it's actually a 20% excise tax penalty payable by the employee.”
^{—Matt Secrist, Partner at Taft Law}

This defeats the purpose of offering equity as a means to incentivize the people who have contributed to your startup's success. You want to make your employees gain profits and not pay a hefty tax bill on top of their hard work.

Essentially, this appraisal protects you and your employees, and can save you big-time down the road. It comes with a bit of a process and some up-front cash, but that pales compared to the fines and drama you open yourself up to otherwise. With the right perspective, you can turn this requirement from a pain to gain.

Quick fire Q&A

FAQs on 409A valuation cost

Some of the most frequently asked questions answered: 

Is a 409A Valuation mandatory?

If you offer stock options as compensation to employees, a 409A is legally required. Without one, your options could be taxed as ordinary income instead of at the lower capital gains rate. 409A valuations also provide legal protection in case the IRS challenges your stock price. For most startups, the benefits outweigh the costs.

How much is a 409A valuation fee?

For an early-stage to mid-stage startup with a straightforward business model and capital structure, you can expect to pay between $5,000 to $10,000 for a 409A valuation. More complex companies, especially those with preferred stock or many stockholders, will likely pay $10,000 to $25,000 or more. If you obtain your 409A valuation from a platform like Cake, you can significantly cut that cost down and pay a one-off fee. With Cake, you can get your 409A valuation at $1,200 on top of your current cap table subscription plan.

How long does a 409A valuation take?

A 409A valuation typically takes between 2 to 4 weeks to complete. The exact duration can vary depending on the complexity of the business, the quality of the provided financial data, and the workload of the valuation firm. However, with Cake's streamlined process, the timeline is cut down significantly to 3 business days.