When startups grant stock options, how do they determine the value of common shares? For a privately-held company, the 409A valuation is the only method you can use to grant options on a tax-free basis to your employees. Basically, a 409A Valuation is an independent appraisal of the Fair Market Value (FMV) of a private company’s common stock or the stock reserved for founders and employees by a third-party organization. This valuation determines the cost to purchase a share.
Why is a 409A valuation required?
The IRS (Internal Revenue Service) introduced section 409A to prevent executives from taking advantage of equity loopholes. 409A facilitates a framework that startups can follow to evaluate their private stocks. As the valuation is conducted by an unaffiliated third-party, it is unbiased and establishes a safe harbor. Also, it is mandatory for startups to abide by 409A rules for issuing the first common stocks. If the startup fails to do so and misprices equity, IRS might charge penalties.
When do startups require a 409A valuation?
A 409A valuation is required:
- Before issuing the first common stock options
- After raising a round of venture financing
- Once every 12 months (or after a material event)
A material event is something that could affect a company’s stock price.
Example – qualified financing events such as the sale of common shares, preferred equity, or convertible debt to independent or institutional investors at a negotiated price
- While approaching IPO or M&As
After 12 months (or sooner, in case of a material event), the startup will need a 409A refresh or updated valuation. 409A refresh is done after any event that could change the valuation.
The data needed for a 409A valuation is relatively straightforward.
- Corporate charter or certificate of incorporation
- Most recent cap table
- Recent pitch deck
- Company historicals and a 3-year P&L, cash balance, and debt projections
- An estimate on how many options you expect to issue over the next 12 months
- A list of 5+ most comparable publicly-traded companies
- Timing expectations around potential liquidity events
- Significant events that have happened since your last 409A
How long does it take to get the 409A valuation done and issue stock grants?
Generally, if all the items in the above checklist are provided, it takes about two weeks to get to a final draft of the 409A valuation. For later-stage companies that have engaged an auditor, the timeline maybe a little longer. A typical timeline involves data collection and kick-off calls, valuation modeling, preparation of draft schedules, and management review in the first two weeks; and then obtaining Board approval and granting options the third week.
A 3-Step Process
Three steps are involved in the 409A valuation process –
- Determining the enterprise value or how much the company is worth
While there are many ways in which financial experts (M&A experts, equity research analysts, or VC firms) can determine the enterprise value there are three main methodologies: market, income, and asset-based. These can be used in combination with each other and the method(s) may change as a company matures.
- Market Approach: Used for early-stage companies that are not generating any profit yet and it’s difficult to predict long-range financial performance
- Income Approach- Used primarily by companies who have achieved scale, a high degree of visibility and predictability in their financial performance, and line of sight to when they expect to become profitable
- Asset-based Approach- This approach is rarely undertaken, but it is done venture-backed companies in the very early stage before any pre-angel financing occurs
- Allocate enterprise value across equity classes to arrive at FMV for common stock
For companies with only common shares, the FMV would just be the enterprise value divided by the fully diluted shares outstanding. However, most privately-held venture-backed companies have at least two, if not more, classes of equity (e.g. Series A/B/C/D/etc. preferred shares along with common shares). In these cases, calculating the FMV of the common shares requires further analysis.
- Option-Pricing Method (OPM)- Used for companies, that are still too early in their development, to identify the timings of specific exit scenarios
- Probability Weighted Expected Return Method (PWERM)- Used for companies that have matured to the point where they can estimate the timings of potential exit scenarios
- Hybrid Method- Used to explicitly model all PWERM scenarios in situations where the company has insight into one or more near-term exits but is unsure about what would occur if those specific plans fell through
- Current Value Method (CVM)- Used for venture-backed companies at an early stage with no material progress
- Apply a discount to FMV taking into account the fact that stocks are not publicly traded
As the stocks are not publicly traded yet, marketability decreases as the company scales. A company that has just raised a Series C may have no interested buyers in its common stock and therefore has a very large discount on FMV, whereas a company that has reached scale and is a credible candidate to be a publicly-traded company has a very small discount. The discounted amount depends on when the next liquidity event is about to take place.
If the valuation isn’t performed by not following any of the above methods, the startup could fall outside of the 409A safe harbor. A safe harbor is a legal provision to sidestep or eliminate legal or regulatory liability in certain situations, provided that certain conditions are met. A safe harbor valuation is one the IRS presumes to be valid.
If penalties are handed out, they can be substantial for employees and shareholders. Penalties include:
- Deferred compensation becomes taxable immediately
- Accrued interest on the revised taxable amount
- An additional tax of 20% on all deferred compensation
Pricing of 409A Valuation
In the US, 409A valuation costs in the range of $1000 to $10,000 depending on the size of the company and the complexity of the valuation. With MyStartupEquity, startups can get their 409A valuation done at a mere cost of $1500*. Contact us now!
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