What is 409A Valuation? When do you need a 409A valuation?
14 May, 2021
Being an entrepreneur, the valuation of your company is something that you will always be thinking about. Valuation here means getting the value or worth of your company. Nonetheless, there are different kinds of valuation types that come into question once you begin your business. And one of the main ones is a 409A valuation. Now, you might be wondering what is a 409A valuation and why do I need it? Well, we are here to help you understand and answer all your questions about this.
What Is a 409a Valuation?
Private companies that want to issue shares to their employees have to get their valuation done. This is because they do not have the share price in the market, unlike the public companies that do. Moreover, this valuation has to be done following some rules set up by the IRS under the IRC Section 409A. And this is what gives it its name - 409A valuation. In short, as per Section 409A in the Internal Revenue Code (IRC), the company has to follow some specific guidelines before they can issue the common stock of the company.
A lot of businesses out there issue share options to their employees as employee compensation. It is used as an incentive to keep the employee with the company for a long time and to appreciate their work. This is also used by startups to give the employees compensation as they are not able to pay them with a high salary. The 409A is meant to make sure that the proper federal income tax is paid on the deferred compensation plans.
In addition to this, it also makes sure that the company offers options that are covered by the safe harbor status of the IRS. If you fail to get the 409A valuation done for your company by a third-party valuation provider, then you will get in trouble with the IRS and it would also create a lot of headaches for your employees. The federal government would tax you and your employees with additional interest payments as well. This would not just cost you a lot but also make your employees very disappointed and they might even leave. It would also put the future acquisition of your company in jeopardy as no one wants to deal with tax issues.
What is 409A safe harbor?
If the company gets a 409A handled as per the IRS guidelines, it becomes eligible for "safe harbor" status. And this would just offer you peace of mind that the IRS would not audit your company and cause any issues. With a safe harbor status, the valuation is considered to be valid in the eyes of the IRS unless they can prove it to be "unreasonable." The only way for you to obtain this status is by hiring a professional third-party firm like Eqvista to prepare the 409A valuation report for you.
To explain better, the valuation is considered to be reasonable if the common shares in the company were valued within 12 months from the date of issuance of the shares. And since then, there should not have been any material change as well, such as a funding round, an acquisition. Etc. If all the requirements are met, then the company doesn't have any burden to prove to the IRS that their stock price is right and reasonable.
How 409a Valuations Work
409A valuations work in a straightforward way. To understand it better, it is vital to understand how companies offer compensation to their employees and how it helps. Let us take an example and see how it works:
Let us assume there is a company, Best Services Inc. They hire a new employee named Ben in the company. But the company is not able to offer him a high salary, so they end up offering this employee the option to purchase 2,000 shares of the company's common stock at the current fair market value (FMV). Let us assume that the price of each share at this moment is $0.50 as per the 409A valuation performed by the company. This is the price that is also known as the strike price in the company.
Now, the company tells Ben that he can "exercise" the option he is awarded after working for the company for 5 years. This time period is called the vesting period. And every company usually has a different duration of vesting period. It can range from 3 years to 5 years. After 5 years, the value of the shares in Best Services Inc reaches $20 per share. And Ben can exercise his options and purchase the 2,000 shares at $0.50 as set initially. So, he is paying a low amount for shares that are worth 40 times more. It is also a benefit for Ben, as he can now sell the stock at $20 and make a huge profit from this.
The 409A valuation here helps in getting the option price that Ben is getting. And the IRS does not want the company to make up any valuation. Although the employee does get the choice to purchase the shares at a low price, keeping a lower strike price than the FMV can lead to some issues. The employee would, later on, have to pay a higher tax and penalties to the government. On that, the company would be accused of hiding their income by giving a low strike price and they would get in trouble with the IRS.
What are the most common 409A methodologies?
To ensure that the safe harbor status is maintained, independent appraisers have to follow specific methods to get the value of the company. Out of the many available methods, here are the three most commonly used methods to get the 409A valuation of a company:
- Market Approach: This is an analysis that compares the private and public companies and transactions.
- Income Approach: The analyst utilizes the free cash flows in the company to find out the projections for the next five years to get the value.
- Asset Approach: This is an analysis of the intangible and tangible assets of the company with those of public companies.
These methods are sometimes used together as well to get a much more accurate outcome.
When Is A Good Time To Get A 409A Valuation?
It is obvious that no one wants any trouble with the IRS and their taxes. And getting at the wrong side of the IRS and causing legal issues, would just ruin the business. But it is also very common for founders to forget or slide some tax considerations when there are a lot of other things that they need to take care of. With all this, it is important to get the 409A done. Here is when you usually need the 409A done:
- Every 12 months.
- When raising a funding round
- When issuing stock options to your employees
The first option says it all. In short, you need to get the valuation done every 12 months. This would help you work on your business better and even help it grow more. It would also help you stay from any trouble with the IRS.
How much does a 409A cost and how long is it good for?
Many 409A valuation providers offer services whose costs range from $1,000 to $10,000 based on the size of the company. But just note that the higher the price, doesn't mean that their services are great. You need to ensure that they have the right certifications and experience before you hire them. For instance, Eqvista offers 409A valuations for startups at $890 and has the NAVCA certification and a lot of experience. You can come across some who have lesser experience and no certifications, but offer the service at a higher rate. So, choose the firm wisely.
Once you get the 409A valuation report, it is great for 12 months or until and unless the company undergoes a material event, including the IPO, funding round, acquisition, and so on. If a material round takes place, you would again need to get your company valued.
What data do I need to provide to get a 409A?
As soon as you have selected the firm to help you with the 409A valuation report, they will ask you to share some information about your business. This can include, but is not limited to, the following:
- Company details - the industry information, name of your legal counsel, name of your external audit firm (if there is any), name of the CEO, and your latest articles of incorporation.
- Fundraising and options - Your company's business plan, the number of options you wish to issue in the next year, and the approximate time of a liquidity event.
- Industry - A list of comparable public companies.
- Company financial statements - Forecasted EBITDA of the next year, forecasted revenue for the next one year, cash burn and runaway, and the non-convertible debt amount.
Along with this, you will also have to share any relevant material event that took place in the last year or after the last 409A valuation (if there was any).
In short, ensure that you get your 409A valuation performed by a professional firm like Eqvista so that you can stay in the clear. Because, if you fail to do so, you and your employees would end up paying more than 20% extra taxes for the shares, with additional interest charges. It is always better to be safe by spending a little initially.
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