Most founders dream about getting their product live and solving real-world problems. Something you're probably not dreaming about? 409A valuations.
But, getting a proper (and founder friendly) 409A is a problem you will need to solve. This resource is here to explain the nuts and bolts of the 409A process and give you a set of guideposts to optimize the results of your next 409A.
1. What is a 409A valuation and how do they work?
First, it is important to distinguish between a 409A and a valuation set by investors during fundraising.
A 409A is used to determine the fair market value (FMV) of your company and is set by a 3rd party valuation service. A 409A is required by the IRS (you can read more here) to set the strike price for common shares (awarded to employees, advisors, etc.) and ensure that options represent their real value.
A 409A valuation is often (but not always) different from the post-money valuation of your company after fundraising. This is because investors are getting preferred stock, which might be valued higher than common stock due to better liquidation preferences.
While it is theoretically possible to run your own financial analysis to determine your FMV very, very early on in the lifecycle of your company, it's almost never worth it because valuations are difficult and take a lot of time. You also run the risk of IRS penalties. Only by using a 3rd party valuation firm will your startup receive safe harbor and protection from IRS penalties.
2. What is Safe Harbor?
Safe harbor means that your company has completed an acceptable valuation in the last year and is protected from having to prove to the IRS that your valuation is accurate. Over 99% of the time this valuation is performed by a 3rd party. In some rare cases (like if you’re an illiquid company, under 10 years old) you can gain safe harbor from having an internal employee with adequate accounting experience do the valuation (we rarely, if ever, see companies go down this road).
What happens if you don’t have safe harbor, the IRS audits you, and the options you issued most recently are deemed not to be properly set at a fair market value?
In this situation, employees who received options at the incorrect price will be taxed on those options immediately, will be fined an additional 20% of the value, and will have to pay other penalties. This is a significant financial burden to employees who should have been protected by a more knowledgeable and responsible founder.
3. When to Get Valuations
As a startup founder, you need to figure out when to get your first and subsequent 409As. Here are some rules to follow:
A new normal: The world of 409As has changed dramatically in the last few years. 409As used to be the sole domain of expensive auditing firms that would charge anywhere from $5,000 to $25,000 to complete a valuation. The same way sites like LegalZoom upended the legal market, Carta has used technology and scale to dramatically reduce the cost of valuations. Now, 409As are inexpensive and affordable, even for companies with less than ten employees (learn more about Carta's pricing here). Want even more info? Check out Jose Ancer’s post on 409As as a Service.
Guidelines on when to get a 409A:
- You should generally get your first valuation when you issue your first common stock options (typically to your first hire or advisor).
- You should get future valuations before raising a round of venture financing.
- Once your company is more mature (greater than ten employees/post-Series A) you should get a new valuation once every year to make sure new employees aren’t hurt from the tax implications of improper valuations (more discussed below)!
- Carta will complete your first valuation at a fraction of the cost of traditional valuations, and we'll update it as materially necessary over the course of the year.
4. Methods and Founder Goals
When it comes to 409As most founders want to set the lowest possible price. Why? This means a lower strike price for employees to exercise options and a greater realization of value if the company succeeds. The lower the strike price of an option, the more the option holder will receive when they sell the underlying stock.
Some founders worry that a lower 409A will make their business look bad to current or future investors. This is not the case. Investors know that a 409A is strictly used to set common stock prices - they won't use your 409A to evaluate your business.
These are the three most common methodologies for a 409A.
This approach is used when your company has recently raised an equity round. It can be safely assumed that new investors paid a fair market value for the equity which helps set the price; however, adjustments must be made given that most new investors are receiving preferred stock. This method is no longer acceptable if material changes have occurred since the last financing to your business, including acquisitions, new product releases, new patents, etc.
This straightforward approach is used for companies that have sufficient revenue and positive cash flow.
This is by far the least common and least supported valuation approach. This is for very early stage companies who have not yet raised money and don’t generate revenue. This approach calculates a company's net asset value to determine a proper valuation for a company.
5. 409A valuation Pitfalls
1. Executive Hires
One reason a 409A is so important is that it sets the strike price for new employee options. When an employee later exercises their options they will be taxed on the difference between the strike price and the current valuation. This can impact any employee but can be especially painful for senior leaders who get larger percentages of ownership in a company.
Let's say you recently hired a VP of sales and gave them 1% of your company, which is valued at $1 million. This ownership stake is in the form of early-exercisable stock options. A week later, your first 409A in over a year is completed and the company is now valued at $10 million. If your new VP wants to immediately exercise their options, they will be responsible for a tax bill of $90,000 (1% of a $9 million increase in value) vs. a tax bill of $0 if they had exercised them a week earlier. Regular valuations and valuations before executive hires provide a more predictable tax basis for employees.
2. The IRS audit
The whole point of doing a proper 409A is to protect your company from a potentially costly audit and to protect your employees from significant penalties. Early stage startups with very low option prices might be the least likely to get audited, but with the current cost of valuations so low, why risk it at all?