What Is a 409A Valuation?

A 409A valuation is an independent third-party valuation of a private company’s common stock. These valuations are needed to grant employees tax-free equity compensation and establish a reasonable stock price for employee stock options.

Why 409A Valuations Matter

409A valuations are required by law for private companies issuing equity or options to employees. Without a 409A, companies risk significant tax penalties from the IRS and lost upside for employees. Some key reasons why 409A valuations matter:

• Compliance: Failing to obtain an independent 409A valuation can result in harsh IRS penalties, including 20%+ taxes on all deferred employee compensation.
• Hiring & Retention: Undervalued stock severely limits the potential upside for employees. Overvalued stock could lead to uneasy questions about the basis for valuation.
• Exits: During due diligence for an acquisition or IPO, poor 409A valuation practices could reflect poorly on management and derail deals.
• Establishing Safe Harbor: A proper 409A valuation provides 12 months of safe harbor that equity grants are reasonably valued. This secures the ability to issue options and recruit talent.

Key Elements of a 409A Valuation

Hiring an Appraiser

Companies hire an experienced 409A appraiser to assess the fair market value (FMV) of common shares. The appraiser must demonstrate competence and objectivity to satisfy IRS requirements.

Analyzing Company Details

The appraiser reviews the company’s financials, capital structure, projections, risks, and liquidity outlook. Public and private market comps are evaluated. Management and the board are consulted.

Selecting Methodology

Common 409A methodologies include the income approach, market approach using public and private comps, and backsolve method based on recent funding rounds. The methodology must meet IRS standards.

Complying with Safe Harbor Rules

The final 409A valuation must comply with IRS safe harbor rules. This includes getting re-appraisals every 12 months or upon material funding/strategic events.

Implications of 409A Valuations

Tax Penalties

If the IRS determines a company didn’t make reasonable efforts to accurately value its common shares, steep tax penalties ensue. Employees can have their deferred comp become immediately taxable and face 20%+ tax rates.

Hiring & Retention Challenges

The 409A valuation sets the exercise price of stock options. Underwater options or the perception prices weren’t set fairly can severely impact morale, recruitment, and retention.

Red Flag in Exits

Experienced acquirers and IPO underwriters scrutinize a private company’s 409A valuation history. Any issues could flag poor processes/controls and can risk deals failing.

How 409As Compare to Venture Valuations

Venture valuations are market-driven based on investor demand while 409A valuations follow IRS rules for reasonable FMV assessment. Other key differences include:

• Methodology: 409As use income, market comps, and backsolve approaches. Venture rounds negotiate based on business traction.
• Stock Class Valued: 409As value common stock. Venture use preferred stock with additional rights/privileges.
• Compliance: 409A valuations require ongoing safe harbor refresh. Venture valuations evolve with business milestones.
• Change in Value: 409A exercise prices remain static while venture values can rise every new funding round.

Despite differences in how valuations are set, the venture round prices often anchor the 409A valuation analysis, adjusted for lack of liquidity. So while methodologies differ, the valuations impact one another significantly.

Why VCs Should Care About 409As

While 409As don’t typically impact round pricing, the valuations impact one another over time. Additionally, poor 409A compliance and processes can reflect extremely negatively on founders and jeopardize hiring, investment, and exits.

Selecting a 409A Provider

The benefits of using an experienced provider include independence, expertise, and letting founders focus on strategic priorities.

When selecting a provider, companies should review the team’s credentials, valuation methodologies, client base, scalability and process efficiency. End-to-end timelines generally span 3-4 weeks assuming prompt submission of required financial and operating data.

Conclusion

A 409A valuation is critical for private companies granting equity compensation. It establishes the fair market value of common shares. Using an experienced provider ensures compliance, safe harbor protection, and insulation from steep IRS penalties for the company and employees. Ultimately, robust 409A governance allows leaders to focus on strategic growth while employees feel confident their equity upside is preserved.