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- A Section 409A valuation is an independent valuation of your start-up's fair market value, thus determining your company’s price per share.
- To comply with the law, you must get a 409A valuation every twelve (12) months or anytime your start-up experiences a “material event.”
- Once you submit the required documentation to your 409A valuation provider, you can expect a final valuation within two to four weeks for your review and approval.
- Once you receive your final 409A valuation, it is only valid for twelve (12) months after the effective date. However, if during that twelve (12) months you have a "material event" occur, then you'll need to obtain another 409A valuation.
- By securing a 409A valuation, your other founders, employees, and board members can appreciate the benefit of receiving equity without fearing potential IRS penalties.
- Getting a required, independent 409A valuation can typically cost anywhere from $2,000 to $5,000 or more, depending on your start-up's circumstances, which can be a bite into the operating account. Compared to the potential IRS penalties for non-compliance, this amount is minuscule.
What is a 409A Valuation?
Any start-up founder knows that when creating a business plan, raising investment money, or projecting financials, one question typically arises: How much is your company worth? This is not always easy to answer, especially for an early-stage start-up. However, it's a question you must answer if you want to attract top-tier talent by granting stock options or raising investment money.
Enter the Section 409A valuation. In 2004, Congress passed the American Jobs Creation Act, which in part included a new section to the tax code: Section 409A, which was in direct response to the Enron scandal of 2001. In the Enron case, the company executives committed fraud by overstating the company's fair market value, making it appear that the company was on a meteoric rise. However, Enron filed bankruptcy in October 2001, and its once sky-high stock plummeted, leaving the shareholders with little to no ownership. Decade-long investigations began through federal lawsuits and SEC investigations, to name a few. However, and most importantly for our discussion here, because Enron’s fraud was not addressed in U.S. insider trading laws, Congress passed Internal Revenue Code Section 409A as part of the American Jobs Creation Act to further address valuing private companies.
Section 409A creates specific methodologies, called “safe harbors,” to determine a start-up's fair market value (as a private company) that is acceptable to the IRS. In short, think of it as an appraisal of your start-up's common stock.
For privately-held companies, a 409A valuation is an independent valuation of your company's fair market value, thus determining your start-up's price per share. By comparison, the fair market value of publicly-traded companies, such as those listed on the New York Stock Exchange, is determined by the day's trading on the exchange itself.
Generally, a 409A valuation consists of three steps:
- The determination of your start-up's enterprise value (i.e., your start-up's worth);
- The determination of your start-up's fair market value across your offered classes of common stock (e.g., such as voting and non-voting); and
- The application of a discount to the fair market value, since the stock is privately-held and not traded on a public exchange. This discount is typically “baked in” to the resulting fair market value.
In this article, we're going to explore how and when to get a Section 409A valuation as well as when to update it.
How Long Does It Take to Get a 409A valuation?
To get a 409A valuation, you'll have to do some homework yourself to submit to your chosen valuation provider. Like any task, the more prepared you are, the faster you'll get your valuation.
First, you'll need to gather the following information for your 409A valuation provider, including:
- Your industry.
- Your corporate documents, such as your articles of incorporation and your charter.
- Your investor presentation or board of directors' deck.
- Your most recent financials, such as your profit and loss (P&L) and cash balance statements from the last three (3) years, or if your start-up is newer, your five (5) year sales and expense projections.
- Your most recent cap table. A cap table, or capitalization table, provides details of your company's ownership by your founders, investors, and any other shareholders.
- Other companies that are similar to yours, ideally publicly-traded, so that your 409A valuation provider can compare those companies' valuations to yours.
- Any liquidity events you anticipate, such as a sale or merger of your company.
Once you submit the above information and any other required documents to your 409A valuation provider, you can expect a final valuation within two to four weeks for your review and approval. However, if you are a later-stage start-up requiring additional documentation, you may have to wait a bit longer to receive your final 409A valuation.
As a start-up founder, you're used to completing most projects and tasks on your own—especially at the beginning of your start-up journey. However, when it comes to 409A valuations, it's best to leave these to the professionals. Since 409A valuations are required by federal law when you offer stock options in your company, you want to make sure you are compliant with the Internal Revenue Code's intricacies.
409A Valuation: When to Do It?
If you and your other founding members wish to issue common stock options to yourselves, employees, board members, or investors, you need a 409A valuation. To comply with the law, you must get a 409A valuation every twelve (12) months or anytime your start-up experiences a “material event,” such as closing a new investment round, like a Series A or Series B round.
Once you receive your final 409A valuation, it is only valid for twelve (12) months after the effective date. However, if during that twelve (12) months you have a "material event" occur, then you'll need to obtain another 409A valuation. A material event is an occurrence that can affect the price of your common stock, such as filing a patent or business model changes. For early-stage start-ups, the most common material event is qualified financing (i.e., the arm's length sale of equity to independent investors).
If you're further down the road with your start-up and are approaching a merger, acquisition, or IPO, then expect to conduct 409A valuations more frequently.
As you begin your 409A valuation process, whether it's every twelve (12) months or after a material event, you'll need to prove to the IRS that the methodology you used to determine your common stock’s fair market value as well as the resulting fair market value itself are both "reasonable." Unfortunately, "reasonable" is not defined in the Internal Revenue Code for this purpose; instead, "reasonableness" depends upon the facts and circumstances surrounding your valuation.
For example, in determining whether a 409A valuation is reasonable, the IRS considers the following:
- The value of your start-up's assets, both tangible and intangible;
- The present value of your current and projected cash flow;
- The objective market value of other companies similar to yours;
- Any recent material developments in your company impacting the stock's value; and
- Any recent sales or transfers of your stock.
However, the IRS does specify that 409A valuations are not considered "reasonable" if they are more than twelve (12) months old.
Because determining the reasonableness of a valuation is somewhat circumstantial, the IRS created three "safe harbor" methods that it deems reasonable if followed:
- A Section 409A valuation performed by an independent appraiser;
- The use of a formula, as specified by the Internal Revenue Code, for fair market value determinations; or
- The person conducting the valuation is qualified to do so, based on experience and training, and does so in good faith. In this case, this person does not have to be independent of your start-up.
As a start-up founder, you should want your 409A valuation to meet the IRS's rules for a reasonable appraisal of your common stock. Additionally, you should want both the valuation and the methodology used to be defensible if it is ever called into question by someone in your company, a court, or the IRS.
When Do You Update Your 409A Valuation?
As discussed above, Section 409A requires you to get an updated valuation after twelve (12) months or sooner if your start-up experiences a material event affecting the price of your common stock. Examples of material events include qualified financing, the issuance of new shares of common stock, significant changes in business models, or merger or acquisition. Even missing or exceeding specific financial goals in a previous 409A valuation can trigger the need for an updated valuation. In determining whether an event qualifies as a material event, thus requiring an updated 409A valuation, you should consult with your start-up's legal counsel.
So, you know when to conduct (and update) a 409A valuation. But what happens if you don't? Or if you do, but it's not considered reasonable by the IRS?
The penalties for not complying with Section 409A are stiff. And worse yet, they are generally imposed on the stock option holders—your employees, board members, and others—not the company itself. First, any stock options granted become taxable immediately instead of later, at the time of exercise, for example. Second, in addition to the immediate tax, the IRS can also levy an additional twenty percent (20%) tax on the stock option holder.
To avoid potential penalties, choosing an independent, third-party auditor is the most conservative safe harbor choice, as the law gives a professional appraiser a rebuttable presumption of reasonableness. Essentially, this means that if you get audited by the IRS, and your 409A valuation was called into question, the IRS must prove that the valuation methodology was unreasonable, instead of you proving it was reasonable. This gives you an added layer of protection – one for which your stock option holders will thank you! Further, violation of this nature can pose both liability and risk to the company itself, holding up future corporate events, such as a merger or sale.
As a start-up founder, you have a lot on your plate to say the least. However, the Section 409A valuation is not something for you to postpone. By tackling this valuation timely and reasonably, as required by the Internal Revenue Code, you'll be able to focus on growing your company, not IRS audits.
Benefits of a 409A Valuation
As an early-stage founder, you often want to reward those that jumped in with you—other founders, employees, or board members. Using equity as part of compensation packages to these early supporters is a great way to reward and retain them.
By receiving a 409A valuation for your start-up's common stock, you are establishing an unbiased baseline of your stock's worth. By securing this valuation, your other founders, employees, and board members can appreciate the benefit of receiving equity without fearing potential IRS penalties.
In addition to assuring your employees, having annual 409A valuations are advantageous as your business grows. By conducting reasonable appraisals over the years, you are building a paper trail of your company's growth, demonstrating your compliance to the IRS if they ever come calling.
By understanding the importance of a 409A valuation, as an early-stage founder, you can assure your team (and the IRS) that your business complies with federal law as you offer early and top talent stock options that will continue to grow in value, just like your start-up.
Limitations of a 409A Valuation
As a start-up founder, your investors may look at different valuations when determining whether to invest in your business. For example, they may look at your start-up's current status, such as the marketability of your product or service or the problem solved by your offering. Or, they might examine what could be accomplished in the future with your start-up, with your team, technology, and/or go-to-market strategy. On the other hand, some investors will invest in your start-up based on you, the founder, and your experience and passion.
However, it's important to note that your investors' analysis may not be the same (and more than likely won't be the same) as a legally-mandated Section 409A valuation. If you are going to offer common stock options, the 409A valuation determines your start-up's true value at a particular point in time.
Additionally, getting a required, independent 409A valuation can typically cost anywhere from $2,000 to $5,000 or more, depending on your start-up's circumstances, which can be a bite into the operating account. Compared to the potential IRS penalties for non-compliance, this amount is minuscule. Even if cash flow is tight, you should get in the habit of paying for a reasonable 409A valuation, setting your start-up on the right and compliant path forward.
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If you're looking for help on getting your 409A valuation done, we can get your documentation ready, connect you with 409a valuation providers, and overall shepherd this process to make sure it’s done right, get in touch with us.
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