A 409A valuation is a specialized assessment of the fair market value (FMV) of a private company’s common stock, which is typically reserved for founders and employees. This evaluation is conducted independently and is crucial for understanding the value of these shares on the date they are issued. It adheres to the guidelines outlined in section 409A of the Internal Revenue Code (IRC) by the IRS.
In simple terms, if you plan to offer equity to individuals who provide services to your company, it’s vital to know the fair market value. Otherwise, you risk facing severe IRS penalties for both your company and the equity holders. So, if you intend to offer equity, seeking an independent 409A valuation is a wise choice.
We’re here to help you grasp the fundamentals of a 409A valuation, enabling you to confidently select a valuation provider. To get an idea of what a 409A valuation report looks like, you can download a sample report.
Do I Require a 409A Valuation?
If you are planning to offer equity or have already done so, it’s considered best practice to obtain an independent 409A valuation before granting common stock options. Early-stage companies and founders also benefit from 409A valuations as they can prevent shareholders from facing IRS-imposed tax penalties. Reputable 409A valuation providers can assist you in taking advantage of IRS “safe harbors.”
When Should I Get a 409A Valuation?
You should obtain a 409A valuation in the following situations:
Before you grant your initial common stock options
After securing a round of venture financing
Annually (or after significant events)
When approaching an IPO, merger, or acquisition
How Long Are 409A Valuations Valid?
409A valuations are valid for a maximum of 12 months from the effective date or until a significant event occurs that could impact the company’s stock price. For many early-stage startups, a “qualified financing” event is the most common significant event. Qualified financing typically involves selling common shares, preferred equity, or convertible debt to independent institutional investors at a negotiated price.
What Constitutes a 409A Material Event?
Apart from financing, other events may be considered material, including:
Obtaining or losing a significant contract that substantially affects revenue, including annual recurring revenue (ARR).
Completing a significant acquisition where your company is either the buyer or seller.
Receiving a term sheet from a potential acquirer.
Forming a strategic partnership likely to open new markets or improve profitability.
Experiencing regulatory changes that significantly expand or reduce your target market.
If you’re uncertain, it’s advisable to reach out to a 409A valuation provider or consult your legal counsel.
Understanding IRC Section 409A
In response to the Enron scandal in 2001, regulators aimed to prevent executives from exploiting equity-related loopholes. In 2005, the IRS introduced IRC Section 409A, which became effective in 2009. This section establishes a framework for private companies to follow when valuing private stock. Conducting the valuation independently or with an unaffiliated party establishes a “safe harbor,” meaning it is considered “reasonable” by the IRS, with some exceptions.
Failure to adhere to 409A rules and incorrectly pricing equity can lead to IRS penalties, often borne by employees and shareholders.
What Is the Cost of a 409A Valuation?
The cost of a 409A valuation can vary widely. Some providers offer standalone valuations, while others bundle services. Standalone valuations typically range from $1,000 to over $10,000, depending on your company’s size and complexity. At Syndicately, 409A valuations are part of an annual subscription that includes cap table management.
What Is a 409A Refresh?
After 12 months or sooner if a significant event occurs, your company will need a 409A refresh, which is essentially an updated valuation. Any event that might alter the company’s valuation requires a new 409A assessment.
Understanding the 409A Safe Harbor
When a 409A valuation is conducted in a specific manner, it qualifies for “safe harbor” status. Think of this as peace of mind: the IRS presumes a safe harbor valuation to be valid unless it can prove that it’s “grossly unreasonable.” The IRS provides three safe harbor methods for determining the FMV of private company common shares:
Independent appraisal presumption
Binding formula presumption
Illiquid startup presumption
The most common approach to achieve safe harbor status is using the independent appraisal presumption, which involves a qualified third-party appraiser. If the stock was valued within 12 months of the applicable option grant date and no material changes occurred between the valuation date and the grant date, the IRS considers the 409A valuation reasonable.
Common 409A Valuation Methodologies
Independent appraisers have a duty to ensure that your 409A valuation and FMV are fair. Three standard methodologies are often used in 409A valuations: the market approach, income approach, and asset approach.
Market Approach (OPM Backsolve)
When your company raises funds, valuation providers usually use the option pricing model (OPM) backsolve method. This assumes that new investors paid fair market value for the equity, but adjustments must be made to determine the FMV for common stock since investors receive preferred stock. Other market-based approaches use financial data from comparable public companies to estimate your company’s equity value.
For businesses with revenue and positive cash flow, the straightforward income approach is employed. This method determines a company’s value based on expected future cash flows, adjusted for risk.
The asset approach is often used for early-stage companies without revenue or funding. It calculates a company’s net asset value to establish its valuation.
What Do I Need for a 409A Valuation?
After selecting a 409A appraiser, you need to compile and share important information about your business. For example, Syndicately requires the following:
External audit firm’s name (if applicable)
Legal counsel’s name
Amended and restated articles of incorporation
A list of relevant and comparable public companies
Fundraising and Options
Anticipated timing of a liquidity event
Company presentation, business plan, or executive summary
Historical financial statements
Revenue forecasts for the next 12 months
EBITDA forecasts for the next 12 months
Cash burn and runway
Non-convertible debt amount
Any significant events since the last 409A valuation (if this is your first-ever 409A, provide a complete history of relevant events)
Understanding 409A Penalties
If your 409A valuation doesn’t adhere to IRS-approved methods, you may fall outside the 409A safe harbor. Penalties for employees and shareholders can be significant, including:
Immediate taxation of all deferred compensation from the current and preceding years
Accrued interest on the revised taxable amount
An additional 20% tax on all deferred compensation
While most startups may not be audited by the IRS initially, as your company grows and approaches an exit, such as a merger, acquisition, or IPO, IRS audits become possible. Working with a reputable valuation provider from the start can save you time and effort.
How Do LLCs Handle Valuations?
Limited liability corporations (LLCs) differ from corporations in terms of their tax and equity structures but still require valuations. Unlike corporations, LLCs can issue both capital interests (common and preferred stock, stock options, and warrants) and profits interest units (PIUs). PIUs are often assigned a liquidation threshold on their grant date, typically equal to the company’s equity value. PIU holders participate pro rata in future exit proceeds for amounts exceeding the liquidation threshold. This threshold is often referred to as the distribution or hurdle threshold.
LLCs must keep track of the liquidation threshold for all grantees to accurately award profits interests if applicable.