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 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.
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).
The answer is actually pretty straightforward:
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:
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.
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:
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.
And Cake Equity is always ready to make your capital raise seamless with workflows, cloud-based cap tables and best-practice legal templates.
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.