What should founders look for in 409A valuation firms?
Getting a 409A valuation is crucial for any startup looking to distribute equity as part of their compensation plans or raise funding. However, 409As are complicated processes, often requiring specialized knowledge and qualifications that take years to complete.
Enter: valuation firms. Comprised of dedicated experts who make providing 409A valuations their bread and butter, valuation firms are a stress-free way for founders to obtain accurate and timely 409A valuations. However, selecting a valuation provider that is both reputable and ideal for your startup can be tricky, but this is where we come in.
In our article, we’ll walk you through why outsourcing your 409A valuation to an independent appraiser is preferable over doing it in-house. Then we’ll go through key questions you should ask any potential 409A valuator to assess their suitability.
Challenges of doing your own 409A valuation
Though handling your own 409A valuation to save money is possible, we strongly advise you to avoid this path. 409As are notoriously difficult processes where one small mistake can snowball into an avalanche of regulatory penalties.
Lack of expertise
409A valuations require in-depth familiarity with intricate legal and financial nuances. Founders need to study the IRS’s dense regulations and properly understand fundamental accounting principles, standards, and market trends. They must also know what specific information they need to gather and include to calculate a 409A valuation. All the while, founders would also be walking on a legal tightrope where any error, omission, or inconsistency, no matter how insignificant, could result in severe consequences.
Waste of resources
Unless you have extensive, specific experience working as a 409A valuator, you’ll need to dedicate large swathes of time and effort to get up to speed. After all, there’s a reason why people dedicate entire careers to delivering 409A valuations. With a startup’s resources already being stretched thin, it would be more beneficial to spend those resources on activities that can directly contribute to growth and development, such as fundraising and networking.
Conflict of interest
Even if you do have the know-how and experience with conducting 409A valuations, doing them in-house can often lead to a heavily scrutinized valuation, with the IRS questioning its accuracy and validity. This is because internal valuations, even when error-free, may be viewed as having a conflict of interest. The startup could potentially be suspected of manipulating the valuation to obtain their desired result.
Benefits of having an expert do it for you
Delegating the task of doing a 409A valuation to an external, independent third-party appraiser is the safest and most advised approach on three fronts — costs, errors, and protections:
While it is true that hiring a 409A valuation firm is costlier than doing it in-house, it’s important to remember two things. Firstly, the potential costs of non-compliance can easily overshadow the price of an independent appraiser. And secondly, costs aren’t always about money, as founders will now have more time to focus on other critical business needs.
Minimal risk of error
Because dedicated experts comprise 409A valuation firms, they can effectively minimize the risk of error.. Valuators are well-versed in all aspects of the valuation process, from compliance to calculation. Also, good valuators can also provide expert advice in an advisory capacity where required (e.g., providing input on how a proposed internal restructuring can impact the startup’s fair market value).
Assuming you’ve selected an independent, third-party appraiser, your valuation will generally achieve safe harbor status. This means that the IRS assumes your valuation to be valid, and the burden of proof would fall on them should any regulatory disputes arise. A startup can benefit in several from having a safe harbor status, including appearing more desirable to investors and having stronger protections against potential penalties.
5 questions you should always ask potential valuators
There are a staggering number of 409A valuation firms in the United States who offer third-party appraisals. Though this may seem good, how can founders find the perfect fit among their available options? Here are five key questions to always ask valuators to help determine whether they’re suitable for you:
#1 “What methods do you use to calculate the value of common stock and why?”
The IRS does not impose a universally specific method valuators must use as part of the 409A process. Still, over the years, a number of common methodologies accepted by the IRS as reasonable and acceptable have emerged, such as the income approach, market approach, and asset approach.
While the specific methodology used should best be left for the experts to decide, it is important to ensure that your valuator is using an industry-accepted method to determine their reputation and credibility; using an unrecognized approach could potentially disqualify your report from safe harbor protections.
#2 “What additional steps do you take to ensure compliance?”
Making certain that your valuator has expertise in relevant regulations and laws is a basic requirement, but what really sets them apart is their commitment to taking extra steps to ensure compliance.
For instance, they could ensure that their 409A valuations are conducted according to standards set by Generally Accepted Accounting Principles (GAAP) and Generally Accepted Valuation Principles (GAVP). These aren’t legal requirements in regard to 409A valuations but they demonstrate that your valuator takes compliance seriously beyond the minimum.
#3 “Do you have any existing case studies demonstrating your success?”
A sure way to gauge the success of a potential valuator is by closely examining their track record of success. This is why founders should request their potential valuators share, if possible, any existing case studies that would shed light on their past work experience and success rate.
Realistically, not all valuators would have this on hand or be willing to share such information. In such cases, founders should defer to online review sites such as G2.com to vet their potential valuator.
#4 “How do you present and communicate your valuation to the client?”
Calculating a 409A valuation is only one part of the equation. The other comes in how the valuator conveys their findings to the founder. 409A valuations are technical and often filled with indecipherable jargon that can easily overwhelm founders. As such, it’s imperative to assess how well a valuator communicates their report, which should be clear and concise. After all, it is important to remember that the valuation report will serve as a reference for key business decisions.
To determine this, founders should ask for samples of previous 409A reports to get a sense of the valuator’s reporting and organization style. Alternatively, founders can also get in touch through a consultation call to get a sense of their communication style and assess how well they can distill complicated information in a simple-to-understand way.
#5 “Do you have experience working with startups similar to mine?”
409A valuators across the board will differ greatly in skillset and work experience. Some may have only worked with large, mature startups, while others may have only served medium-sized startups. The point is that, like two startups, no two 409A valuators are ever the same. This is why founders must strive to ensure their potential valuator can fulfill their startup’s unique needs.
To achieve this, consider looking at the clients they’ve worked with in the past. Are those startups similarly sized and operating in the same industry? Answering this will help determine whether your valuator has the specialized knowledge required for your needs.
Obtaining a 409A valuation is a critical step for startups looking to distribute equity or raise funding. While the process can be complex and time-consuming, valuation firms offer a stress-free solution with their specialized expertise. However, selecting the right valuation provider requires careful consideration and asking key questions to assess their suitability. Ultimately, partnering with a reputable and well-suited valuation firm can help startups navigate the complexities of 409A valuations with confidence.
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