A 409A valuation represents an impartial assessment of the fair market value (FMV) of a private company's common stock (the primary security allocated for founders and employees) at the time it is issued. This appraisal is guided by the principles and regulations outlined in section 409A of the IRS's Internal Revenue Code (IRC).
Simply put, knowing the fair market value is essential when offering or issuing equity to service providers, as failing to do so can lead to significant IRS penalties for both the company and the equity holders.
Therefore, obtaining an independent 409A valuation is a wise move if you're considering offering equity.
In our article, we'll guide you through the fundamentals of a 409A valuation, enabling you to select a valuation provider confidently.
Is a 409A valuation necessary for me?
If you're issuing equity (or intend to), securing an independent 409A valuation is strongly recommended prior to distributing your initial common stock options. Startups and founders likewise require 409A valuations to shield investors from potential tax penalties imposed by the IRS; engaging a credible 409A valuation firm can assist in leveraging "safe harbors" (explained further below).
Also read: https://www.inkle.io/landing-page/tax-form-1120-what-it-is-your-complete-guide
When is a 409A valuation necessary?
Consider obtaining a 409A valuation under the following circumstances:
- Prior to distributing your initial common stock options
- Following a venture financing round
- Annually or subsequent to a significant event
- As you near an Initial Public Offering (IPO), merger, or acquisition
What is the validity period of 409A valuations?
409A valuations under the Internal Revenue Code (IRC) remain effective for up to 12 months from their issuance date or until the occurrence of a material event, whichever comes first. A material event refers to any occurrence that might influence the company's stock value.
For many early-stage startups, the event most frequently affecting valuation is "qualified financing." This involves the sale of common or preferred shares, or convertible debt, to independent, institutional investors at an agreed-upon price.
What qualifies as a material event for 409A purposes?
Apart from financial transactions, various situations might be deemed significant enough to influence a 409A valuation:
- Gaining or losing a substantial contract that leads to a significant shift in revenue, including changes in annual recurring revenue (ARR).
- You are completing a material acquisition, whether your company is acquiring or being acquired.
- You are receiving a term sheet from a prospective buyer.
- When you are forming a strategic partnership, it is anticipated to access new markets or enhance profit margins.
- You are experiencing regulatory adjustments that markedly expand or shrink your potential market size.
- If you need more clarification about whether an event qualifies as material, it's advisable to consult with a 409A valuation specialist or your legal advisor.
What does IRC Section 409A entail?
In 2001, regulators sought measures to curb executives from exploiting equity-related loopholes. This led to the introduction of IRC Section 409A by the IRS in 2005, with its definitive version being implemented in 2009.
Section 409A provides guidelines for private companies on how to value their stock appropriately. Conducting this valuation through an independent party grants a "safe harbor" status, which the IRS typically accepts as "reasonable," barring certain exceptions.
Failure to comply with Section 409A's regulations and incorrect pricing of equity can lead to IRS penalties. In such cases, it's often the employees and shareholders who bear the financial burden.
What is the expense associated with a 409A valuation?
The price for a 409A valuation can vary significantly, with some firms providing it as a singular service and others including it in a package of services. For individual valuations, fees can range from $1,000 to upwards of $10,000, influenced by your company's scale and intricacy.
What does a 409A refresh entail?
A 409A refresh is required every 12 months or sooner in the case of a material event and is essentially an updated assessment of your company's valuation. Any occurrence that could alter the company's worth necessitates a new 409A valuation.
What does "safe harbor" mean in the context of a 409A valuation?
The concept of "safe harbor" applies when a 409A valuation is conducted following certain criteria, offering a level of security. This means the IRS is likely to accept the valuation as valid unless they can prove it to be "grossly unreasonable."
The IRS acknowledges three methods for establishing the fair market value (FMV) of private company common stock under safe harbor provisions:
- Presumption based on an independent appraisal
- Presumption based on a binding formula
- Presumption for illiquid startups
The preferred method for securing safe harbor status typically involves the independent appraisal presumption, which relies on an evaluation by a qualified external appraiser.
A 409A valuation is considered reasonable by default if it values the stock within 12 months before the relevant option grant and if no significant changes have happened between the valuation and the grant dates.
Under these conditions, the IRS has the challenge of proving any valuation to be "grossly unreasonable."
Key 409A Valuation Techniques
Valuation experts are tasked with ensuring the fairness of your 409A valuation and fair market value (FMV). They typically employ one of three principal methods during a 409A valuation: the market, income, and asset approaches.
Market Approach (OPM Backsolve)
In instances of fundraising, valuation practitioners often resort to the option pricing model (OPM) backsolve technique. This method operates under the presumption that new investors have paid a fair market price for their shares. However, since these shares are usually preferred stock, adjustments are necessary to ascertain the FMV of common stock. Additionally, this approach may involve analyzing financial metrics such as revenue, net income, and EBITDA from similar public entities to estimate a company's equity value.
Income Approach
This approach is suitable for companies with significant revenue and positive cash flows. It assesses a company's value based on its anticipated future cash flows, adjusted for any associated risks. This method is straightforward and focuses on the income-generating capability of the business.
Asset Approach
Typically applied to early-stage ventures without fundraising or revenue, the asset approach estimates a company's value by calculating its net asset value. This method is particularly useful for determining a foundational valuation for companies in their nascent stages.
Preparing for a 409A Valuation
After choosing a 409A valuation firm, you'll need to gather and provide critical data about your company.
Company Information
- CEO's name
- External audit firm's name (if you have one)
- Legal counsel's name
- Amended and restated articles of incorporation
Industry Details
- Your sector
- A list of similar and relevant publicly traded companies (Many 409A valuations use comparisons with these companies)
Fundraising and Equity Details
- Expected timing for a liquidity event
- Company presentation, business plan, or an executive summary
Financial Data
- Historical financial statements
- Revenue forecasts for the next 12 months and the following two calendar years from the valuation date
- Projected EBITDA for the next 12 months and the following two calendar years from the valuation date
- Information on cash burn and runway
- Total non-convertible debt
Additional Information
- Any significant events that have occurred since your last 409A valuation or, if this is your first valuation, a comprehensive history of relevant events
Consequences of Non-Compliance with 409A Valuation Requirements
Please conduct your 409A valuation in accordance with IRS-sanctioned methods to avoid falling outside the 409A safe harbor protections. The repercussions for employees and shareholders can be severe, including:
- Immediate taxation of all deferred compensation for the current and previous years.
- Interest charges on the recalculated taxable amount.
- An extra 20 percent tax penalty on all deferred compensation.
While startups may not typically be the focus of IRS audits, the likelihood of scrutiny increases as a company expands and nears a financial event, such as a merger/acquisition or initial public offering (IPO).
To mitigate risks and potential penalties, partnering with a credible valuation provider from the start is advisable.
Handling Valuations in LLCs
Limited Liability Companies (LLCs) have distinct tax and ownership structures compared to corporations, yet they also necessitate valuations.
In contrast to corporations, LLCs can distribute capital interests (such as common and preferred stock, stock options, and warrants) and profits interest units (PIUs).
PIUs typically have a liquidation threshold set at the grant date, usually mirroring the company's equity value. Holders of PIUs stand to gain a proportional share of any exit proceeds that exceed this liquidation threshold. This threshold is commonly known as the distribution or hurdle threshold.
It's crucial for LLCs to meticulously monitor this liquidation threshold for all recipients to ensure accurate allocation and distribution of profits interests in future transactions.
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