As the founder of a startup, you may come across a few technical terms that may be unfamiliar. In the US, one such term is ‘409A valuation,’ which you’re going to hear as soon as your company issues stock options. So what is it, and why should you know about it? Read on to find out.
What is 409A Valuation?
A 409A valuation is a third-party, independent appraisal of the fair market value of a private company’s common shares. The assessment conclusions are reported to the company’s board of directors in the form of a written valuation report, which is used to decide and set the price at which people can buy shares of the company’s common stock.
In the US, the Internal Revenue Service has mandated equity valuation vide Section 409A of Internal Revenue Code (IRC), which is known as 409A Valuation, in the following circumstances:
- After every 12 months
- Before issuing equity shares
- When a significant (‘material’) financing event occurs. An event is considered material if it has an impact on the share price. Typically, each round of financing is considered a material event.
- Drastic changes in the business, like a merger or an acquisition
If a material event occurs after the annual valuation exercise is completed, companies can opt for a ‘409A refresh’, which uses the annual valuation as a base and captures the impact of changes from the date of the most recent valuation. This way it becomes easier for startups at the time of fundraising.
Non-compliance to 409A valuation has severe tax implications. These are:
- Immediate taxability of accumulated deferred compensation to date
- Interest on the taxable amount mentioned in the previous point
- Additionally, a 20% tax on all deferred compensation
What is a 409A Safe Harbor?
A safe harbor is an additional layer of security that is included in the valuation exercise, to cushion the company and its stakeholders financially and legally. It is applicable only if an independent appraiser values the company.
For determining the FMV of private company common shares, the IRS provides three safe harbor methods:
- Independent appraisal presumption
- Binding formula presumption
- Illiquid startup presumption
Why Do You Need a 409A Valuation?
For starters, you need it simply because the law demands it. Compliance. The purpose of valuing a business in this context is to determine a reasonable exercise price or share price, without the scope for intentional undervaluation. Any company issuing stock options requires a 409A valuation.
The Internal Revenue Bulletin (IRB) published by the IRS lays down the guidelines for valuing stocks.
According to the IRB, the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method. Whether or not a valuation method is reasonable depends on factors such as:
- Present value of future cash flows
- Value of assets and liabilities on the date of valuation
- Value of similar companies that are listed (and therefore easier to value)
- Inclusion of all relevant information for ascertaining the value
Stocks that are readily tradable on an exchange need to be valued at their average selling price within the past 30 days.
What Factors Influence 409A Valuations?
For unlisted shares, the IRB suggests three approaches to 409A valuation that can be used, which are discussed below:
1. Income Approach
The Income Approach focuses on the earnings primarily from the principal revenue-generating activity of a firm. It keeps numbers like the EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) as a base for calculating the value of the business. This method is suited for startups that already have financial statements for at least the past 2 years. The longer this period, the more accurate the valuation.
2. Market Approach
The idea behind the Market Approach to valuation is that a company’s value depends on how it performs relative to its peers. This method works well when a startup is founded in an industry where there are at least a few competitors. It is even more useful if they are listed and some key information is available publicly.
3. Asset Approach
This is a rarely used approach that is suited for startups whose business models involve heavy asset utilization and the asset quality impacts the quality of the deliverables to customers and revenue quite significantly.
Once you have chosen one approach, the 409A valuation process has three steps. To know more about this process, read this blog.
Can I Do My Own 409A Valuation?
Regarding the question: ‘can I do my own 409A valuation?’, the short answer is yes. But there’s a catch.
The IRS offers three options to get the 409A valuation done, they’re:
- Do it Yourself
- Use Software
- Hire a Firm
Of the three mandated methods, Do it Yourself is the riskiest. Precisely, it is because there is no “safe harbor” protection should the IRS get involved. That means you must demonstrate that your estimate is correct. You may save money by doing things yourself, but you may also make blunders. Hence, it is always recommended to approach professionals.
How Do You Calculate 409A Valuation?
As you can see, the 409A valuation exercise cannot be completed successfully with a rudimentary understanding of accounting. Hence the answer to your question — how do you calculate 409A valuation is — you need a set of professionally qualified, well-experienced, efficient and ethical subject matter experts, who know exactly what they are talking about. It is important that these independent appraisers have no reason for a conflict of interest while performing the valuation exercise.
trica equity partners with Aranca to deliver quick yet comprehensive 409A valuation services in the US. Aranca has completed over 6000 valuations since its inception in 2005. Our valuations come with a safe harbor and take into account all the macroeconomic, industry-related and firm-specific factors for arriving at an accurate value.
We go one step beyond compliance with the IRS norms and act as an informative tool for auditors and investors.
Get in touch with us today for a free demo of 409A valuation!