At their core, startups are melting pots of promising ideas, big ambitions, and hard work. But these alone aren’t enough to fuel and sustain a startup’s development. Founders must also think about hiring the right people in order to make their mission a reality. However, this is easier said than done, given how thinly a startup’s resources can be stretched.
This is where stock options enter the picture. Used as an attractive form of compensation for existing employees and potential hires, offering equity is a sure way to attract and retain talent. But before a startup can go down this route, they’ll need to put a price tag on their shares.
409A valuations step in here: they are both a regulatory requirement and a way of assessing the price of a startup’s shares. Moreover, they also represent a major hurdle all startups must overcome. To guide founders through the process, we’ll walk you through the A to Zs of 409A valuations from definition to calculation.
What are 409A valuations?
A 409A valuation is an appraisal of your startup conducted by an independent, third-party appraiser (e.g., through a valuation provider like Aranca). This process determines the fair market value (FMV) of a startup’s common stock and is used to calculate the strike price (also referred to as the exercise price), which establishes the price at which a startup’s shares can either be bought or sold.
That said, a 409A valuation is more than just an appraisal. It is also a strict regulatory requirement established under Section 409A of the IRS’s Internal Revenue Code (IRC) which startups must comply with to avoid hefty penalties. In the eyes of the law, the valuation serves two purposes:
- It calculates the price of a startup’s share, ensuring accuracy for its prescribed price.
- It keeps founders and employees protected from inequitable situations.
Why do startups need a 409A valuation?
Startups need 409A valuations for several reasons: if they want to grant stock options to employees (e.g., under equity compensation plans), wish to avoid legal penalties, or are currently trying to raise funding
What do 409A valuations require?
Whether a startup decides to do a 409A valuation in-house or through an independent appraiser, the information and materials required for the process are generally the same.
While the specific documentation and information required will vary based on the startup’s situation and valuator of choice, startups are usually required to produce the following as part of the 409A valuation process:
Consequences of not getting a proper 409A valuation
The imposed penalties for non-compliance with IRC Section 409A are both severe and entirely non-negotiable. They are capable of overwhelming startups of all sizes and stages and have led to the downfall of many. Neither founder nor employee is safe when it comes to non-compliance, as potential consequences include:
Common 409A valuation mistakes
Getting a 409A valuation and fully understanding its finer details can be tricky, often taking founders years to fully work it out. Along the way, some of the most common mistakes made by startups include:
How to get a 409A valuation
In the majority of cases, 409A valuations are performed by independent appraisers as opposed to the startup itself (i.e., in-house). While this is the most popular and recommended method, it is technically possible to get a 409A valuation through other means:
Option 1: Doing it yourself
Doing a 409A yourself may seem appealing due to the money saved — especially for smaller, early stage startups whose financial records aren’t convoluted yet. However, opting to do your own valuation in-house nowadays is rare and unadvised as 409A valuations are complex affairs. The potential downsides of making a mistake far outweigh any upsides in doing it yourself:
Option 2: Using online tools
Startups can also use software to generate their 409A valuation report. Even so, while this may seem preferable compared to doing it entirely by yourself, it suffers from similar issues to the first option:
Option 3: Engaging a qualified, third-party valuator
Seeking the services of an independent appraiser is the best way to ensure your 409A valuation is as accurate as possible and able to protect both you and your employees from regulatory disputes:
Evaluating your valuator
Simply knowing that hiring an independent appraiser is the preferred method is only half the battle. The other half comes in knowing what to look for in potential valuators. As a general rule of thumb, you should always consider the following questions:
How 409A valuations are commonly calculated
While there is no single, universally imposed method that is required to calculate 409A valuations, several common methodologies have emerged which are commonly used by valuators — sometimes together — depending on the specifics of a startup.
The market approach
Ideal for smaller, early-stage startups, the market approach is often used when valuators find it challenging to accurately assess how well the startup might perform in the short and long run. By closely examining the performance of other public companies that share similar characteristics and are in the same industry, the startup being valuated is compared to them and the subsequent findings are then used to inform the 409A report.
The income approach
Often used for startups who have achieved a degree of success in establishing their presence and performing steadily in terms of financial performance, the income approach values a startup by assuming that value comes from projecting the future performance of the startup and discounting those findings from its present value. In other words, this approach assumes that how much a startup is worth is directly related to the startup’s ability to generate returns in the future.
The asset approach
Compared to the other two methodologies, the asset approach is relatively simple and is usually used for very early-stage startups that are still pre-revenue. By examining the startup’s assets and liabilities, the asset approach assumes that the value of a startup can be calculated by substrating the value of its assets from its liabilities.
Getting a 409A valuation is one of the most important things a startup cannot afford to get wrong. That's why it's important that it is conducted by an independent, third-party appraiser and is not only an appraisal but also a strict regulatory requirement under the IRS's Section 409A. By properly complying with the 409A valuation requirement, startups can avoid hefty penalties and create a foundation of fairness and transparency in their equity compensation plans.
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