As a startup founder, you will likely encounter something called a 409A valuation. This post will outline five key things that you need to know about it.
409A valuations are essential in determining your company's estimated value and can have tax consequences when not done properly
So it is important to understand the basics first. By looking into the valuation process, you will be able to better understand the implications.
409A valuations determine the fair market value of privately held company equity in accordance with IRS regulations. Companies do this when they issue stock options or other equity-based compensation to employees or service providers.
The purpose is to ensure that the exercise price of stock options is not less than the fair market value of the underlying stock on the grant date and to avoid penalties under the Internal Revenue Code.
409 valuations are performed by independent, third-party appraisers using certain valuation methodologies such as a discounted cash flow approach or a comparable company analysis (CCA).
The discounted cash flow analysis, for example, estimates the future cash flows of a company and compares them to the current market value of the company's equity. We discuss more on these methodologies below.
Four primary methods can be used to value a company in a 409A valuation: the market approach, the income approach, the cost approach, and the discounted cash flow method.
Choosing the most suitable method depends on several factors, including the type of company valued and the valuation's purpose.
In choosing a 409A valuation method, it is important to choose one that is appropriate for the company’s type of business or industry and its stage of development. Other standard methods include the comparable companies' method, the preferred stock method, and the discounts for lack of marketability.
The valuation process can be complex and time-consuming, and there are some common mistakes that startups or founders make in 409 valuations.
One common mistake is underestimating its cost. A valuation can be pricey, and often startups underestimate how much it will cost.
As a result, they may spend more on the valuation than they had initially budgeted for. Another common mistake often made is failing to account for all of the company's outstanding equity.
All too often, valuations only consider preferred shares, and common shares are left out of the equation. This can lead to an inaccurate valuation, as common shares typically make up a significant portion of a company's equity.
Finally, another mistake sometimes made during a 409A valuation is using an inexperienced or unqualified valuator. It's essential to choose a reputable evaluator who has experience with 409a valuations to ensure an accurate valuation.
By avoiding these common mistakes, startups and founders can ensure that they are getting what they need in a 409 valuation.
For early-stage companies, typically range from $5,000 to $15,000. For more established companies, this can range from $20,000 to $50,000.
409A valuation costs generally include the cost of the valuation report and any associated consulting fees. The cost will vary depending on the complexity of the company's equity compensation plan and the number of employees that need to be valued.
If a company does not have a 409a valuation, there could be consequences. For one, the IRS could impose significant tax penalties for non-compliant equity plan offerings.
In addition, the company could be subject to increased scrutiny from investors and lenders. Without a 409a valuation, it may also be difficult for the company to attract new investments or secure loans.
As a result, not having a valuation can affect a company's ability to operate effectively and efficiently.
There are a few things to keep in mind when getting a 409a valuation done for your startup:
1. Make sure that you engage a third-party appraiser that is qualified based on IRS standards (e.g., the appraiser must have the necessary knowledge, expertise, and educational qualification and training). Using an unqualified appraiser could invalidate your valuation.
2. Be aware of the different methods used to value your company's stock. Each method has its strengths and weaknesses, so you'll need to choose the one that best suits your company's situation.
3. Don't forget to update regularly. As your company grows and changes, so will the value of your common stock. A yearly updated valuation will help ensure that your options are pretty priced and compliant with IRS rules.
As you can see, getting a 409A valuation can be costly, complicated and confusing. In some types of equity plans such as Upstock’s restricted stock units (RSUs), a 409 valuation may not be necessary in certain circumstances or, if needed or deemed ideal, it could be delayed on a later date.
If you want to know more about how Upstock’s RSUs can possibly avoid 409a complications, you can book a call with us HERE.
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