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 a fundraise.
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 a fundraise. This is because investors are getting preferred stock, which might be valued higher than common stock due to better liquidation preferences.
At the earliest stages of a company it is possible to run your own financial analysis to determine your FMV (but even this isn’t usually worth it from a time & cost perspective); however, only by using a 3rd party auditor will your startup receive safe harbor and protection from an IRS audit.
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. 99% of the time this valuation is done by a 3rd party because in some rare cases (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).
So, 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, as well as, required to pay an additional 20% of the value as a fine plus have to pay other penalties. So basically your employees will incur a huge financial burden and it will be your fault.
3. When to Get Valuations
As a startup founder, you need to figure out when to get your first and future 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, eShares has used technology and scale to dramatically reduce the cost of valuations. Now, 409As are inexpensive and affordable even for companies under 10 employees and there is little to no reason not to get a valuation or to try and do one yourself (learn more about our pricing here). Want more info? Check out Jose Ancer’s post on 409As as a Service.
Guideposts 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 an institutional fundraise.
- Once your company is more mature (greater than 10 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)!
- With eShares, you can not only get your first valuation at a fraction of the cost of traditional valuations--you can update it before key hires or fundraises within 48 hours and at no additional cost to your annual plan.
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 buy options, less taxes for employees buying options and more.
Some founders worry that a lower 409A will make their business look bad to current or future investors. Don't worry, this is not the case. Investors know that a 409A is strictly used to set common stock prices and won't use your 409A to evaluate your business.
Since 409As are typically driven by companies and founders, normally you will be in charge of setting this price.
These are the three most common methodologies for a 409A.
- Market Approach:
This approach is used when a 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 major changes have occurred since the last fundraise including acquisition, declarations of bankruptcy, new patents, etc. or if it has been over 18 months since your last fundraise.
If it has been over 18 months since your last fundraise and your company is making some revenue (typically over $250,000) then there is another market based approach that can be used. This is called a CBF approach and looks at your revenue multiples and compares them to other companies in your industry to determine a fair value.
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 have revenues. This approach calculates assets minus liabilities 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 buys their options they will be taxed 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 options.
In an extreme example let’s say you recently hired a VP of sales giving them 1% of your company valued at 1 million dollars. Let’s say a week later you do your first 409A in a over a year and the company gets newly valued at $10 million. If your new VP of Sales wants to immediately buy their options (which they may for a variety of reasons) they will get taxed on a profit of $90,000 (1% of a $9 million increase in value) vs a profit of $0 if they had exercised them a week earlier. Regular valuations and valuations before big hires smooth out the financial value of your employees options rather than having them be erratic.
2. The IRS audit
The whole point of doing a proper 409A is to protect your company from a potentially costly audit. 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?