409A Valuation: How it Works and Common Questions

In this guide, we explain what a 409A valuation is along with the process from start to finish of getting a valuation for your business.

Table of Contents: 

1. What is a 409A Valuation?
2. What Triggers a 409A Valuation?
3. What is the Process for Getting a 409A Valuation?
4. What to Look for in a 409A Valuation Firm?
5. Information Needed for a 409A Valuation
6. Common Methods to Calculate a 409A Valuation
7. Can I Do My Own 409A Valuation?
8. What is 409A Valuation Safe Harbor?

What is a 409A Valuation?

A 409A valuation is an assessment of the fair market value (FMV) of a private company’s common stock. Under Section 409A of the Internal Revenue Code, companies are required to ensure that stock options are issued at a price not less than their FMV. This valuation is typically performed by an independent third party to ensure compliance and protect against penalties. 

What is the Purpose of a 409A Valuation?

The 409A valuation is used to set the exercise price for stock options issued to founders, employees, and anyone else who receives the company stock. By conducting a 409A valuation to determine the fair market value of a private company’s common stock, startups ensure compliance with federal tax regulations and prevent potential tax penalties for both the company and its employees. 

Why is it Called a 409A Valuation?

One word: Enron. The 409A valuation gets its name from Internal Revenue Section 409A. This section was passed as part of the American Jobs Creation Act of 2004 to close loopholes exploited during the Enron accounting scandal.

What Triggers a 409A Valuation? 

It’s a common question, “Do startups need a 409A valuation?” Not all do, but there are a few scenarios that may trigger the need for getting a 409A valuation. Here are the most common triggers:

1. Issuance of Stock Options: When a company plans to issue stock options to employees, a 409A valuation is required. This ensures that the exercise price, also called the strike price, of the stock options is not less than the fair market value of the shares on the date of grant.
2. Annual Review of Current 409A Valuation: The IRS requires that a 409A valuation be updated at least once every 12 months. This is to ensure that the valuation remains accurate and compliant over time. Some more mature companies undergo bi-annual refreshes of their 409A valuation.
3. Material Event: This includes any event that could significantly alter the value of the company’s equity. Examples include receiving a new round of funding, significant changes in revenue or profitability, mergers and acquisitions, or other strategic changes in the business.
4. Preparation for Exit Events: If a company anticipates a public offering, sale, or other liquidity event, a 409A valuation is often conducted to provide up-to-date information on the valuation of common stock.

Understanding and complying with these triggers is critical for remaining in compliance with Section 409A of the Internal Revenue Code, helping companies avoid penalties resulting from your startup’s equity compensation. 

What is the Process for Getting a 409A Valuation?

For new startup founders, the idea of getting a 409A valuation can be daunting. But once you know the steps, it’s a rather straightforward valuation process. From partnering with a 409A appraising firm to getting your final report, you can have a 409A valuation accomplished in a matter of weeks.

What to Look for in a 409A Valuation Firm?

When selecting a firm to conduct a 409A valuation, it’s essential to ensure that they can provide accurate and defensible valuations that comply with IRS regulations and meet the specific needs of your company. Here are several key factors to consider:

• Expertise and Experience: Look for a firm that specializes in 409A valuations and has a deep understanding of the complexities involved. Experience with companies at similar stages and within the same industry as yours is particularly valuable.
• Reputation and Credibility: Check the firm’s reputation within the industry. A firm with a good track record and positive client testimonials is likely to provide reliable service.
• Methodology and Rigor: Ask the firm you are interviewing what methodologies they use for 409A valuations. They should be willing to discuss and justify the approaches they use, including how they determine discount rates and apply discounts for lack of marketability.
• Compliance and Updates: The firm should be experts on IRS guidelines and any changes in the regulatory environment affecting 409A valuations. A good firm is proactive in suggesting valuation updates when triggered by material events or annual review requirements.
• Communication and Support: A 409A valuation impacts strategic decisions for your startup. Because of this, choosing a firm that communicates clearly and is responsive to your needs will help guide you and your firm’s leadership.

Tip: Ask valuation firms for case studies and sample 409A valuation reports from past clients who are similar to you. Seeing their past work will demonstrate their communication and valuation methodologies, allowing you to compare potential valuation firms.

Information Needed for a 409A Valuation

As you work with a 409A valuation firm, you’ll need to provide a set of information to conduct the valuation. Most of the information should be readily available. Here is a general guide for what your valuation firm will need:

• Financial Statements: Recent balance sheets, income statements, and cash flow statements, typically for the last three fiscal years.
• Business Plan, Board Presentation, or Pitch Deck: Documents detailing your business model that include projections of revenue, expenses, and cash flow for the next few years.
• Company’s Capital Structure: Details of your company’s cap table, including all classes of equity (common stock, preferred stock, etc) and terms of any outstanding securities.
• Stock Option Plan: A copy of the current stock option plan under which grants are being made, including any planned amendments.
• Industry Analysis: Information on your company’s market, including a list of comparable public companies to serve as your “comps” which generally only change if new comps enter the market or current comps are acquired.
• Materially Relevant Events: Significant contracts, joint ventures, partnership agreements, or customer contracts that may significantly impact the company’s operations and valuation.
• Potential Liquidity Events: Any timing plans around initial public offerings or mergers and acquisitions.

Common Methods to Calculate a 409A Valuation

There are a few steps to calculating your private company’s 409A valuation. In this section, we walk you through the three steps to calculate a 409A valuation:

1. Calculating enterprise value
2. Determining the value of the common stock
3. Applying a discount rate for lack of marketability.

Calculate Your Firm’s Enterprise Value

There are three general approaches for calculating your firm’s business enterprise value:

1. Income Approach: Also called the discounted cash flow method, the income approach focuses on the company’s future cash flows, discounting them back to their present value using an appropriate discount rate. It is particularly useful for companies that have predictable and stable cash flows.
2. Market Approach: This involves comparing the company to similar businesses in the same industry that are publicly traded or have been recently sold. The method uses multiples derived from these comparables, such as price-to-earnings or price-to-sales ratios, to estimate the company’s value. This approach is best for unprofitable, early-stage companies that also have a clear set of peers or competitors.
3. Asset Approach: This valuation method is based on the company’s assets and liabilities, calculating the net asset value by subtracting total liabilities from total assets. This approach is often used for companies with tangible assets or those in liquidation scenarios. It focuses solely on the balance sheet and does not take future earnings into consideration. It’s rare for venture-backed companies to use this method.

Determine the Value of the Common Stock Price

In rare cases, for very early-stage companies that may only have common stock, we can use simple arithmetic to arrive at a fair market value per share. But in most cases, startups will have to use one of two methods to price a share of stock.

1. Option Pricing Model (OPM): OPM is commonly used in 409A valuations when a company has complex cap tables with multiple classes of equity. OPM treats each class of equity as a call option on the company’s total equity value, with different exercise prices and terms corresponding to each equity class’s liquidation preferences. This model provides a framework for allocating value between different classes of equity based on their relative seniority and rights.
2. Probability-Weighted Expected Return Methodology (PWERM): PWERM estimates the fair value of each share of stock by considering various future scenarios of an IPO, merger or acquisition, or continued private operations. For each potential scenario, a probability is assigned based on the likelihood of each occurring. The expected value of the company’s equity is then calculated by weighting the potential outcomes by their respective probabilities and considering the present value of each outcome. This method is common for companies that have foreseeable liquidity events in the near future.

Applying a Discount Rate for Lack of Marketability

After determining the value of your stock price, the final step in the per-share calculation is to apply a discount. This discount reduces the value of a share of stock due to the challenges associated with selling or transferring these shares compared to more liquid, publicly traded stocks. 

Various approaches are used to calculate the discount rate for lack of marketability (DLOM). These include using benchmarking from other comparable companies and varying quantitative analyses. According to the Corporate Finance Institute, DLOM ranges from 30% to 50%, depending on the company.

Can I Do My Own 409A Valuation?

Technically, a company can conduct its own 409A valuation, but it is generally not advisable unless you have extensive experience with 409A calculations. If you don’t conduct a 409A valuation properly, you risk being out of compliance with the IRS, which can result in penalties for you and your employees. You may also struggle to meet the requirements for a Safe Harbor 409A valuation. Additionally, conducting a valuation requires significant time and resources, which could detract from core business activities. Outsourcing your 409A valuation to specialists allows you to focus on its primary operations.

What is 409A Valuation Safe Harbor?

The 409A valuation safe harbor is a provision that offers companies protection from IRS challenges to the valuation of their stock as long as certain conditions are met. Essentially, if the valuation is performed in compliance with the safe harbor rules, it is thought to be reasonable and compliant with Section 409A of the Internal Revenue Code.

Generally, to qualify for safe harbor, the 409A valuation must be performed within 12 months of the relevant transaction (e.g., granting stock options) and conducted by an appraiser or “qualified individual” who has significant knowledge, experience, education, and training in performing similar valuations. The valuation findings should be communicated in a written report. 

Other 409A Valuation FAQs

Here are a few other common questions startup founders have about the complexities of 409A valuations. 

Do You Want a Low 409A Valuation?

Generally, companies may prefer a low 409A valuation because it allows them to offer stock options to employees at a lower exercise price, making the options potentially more valuable to employees if the company’s stock value increases over time. However, a private company’s common stock valuation needs to be realistic and compliant with IRS guidelines to avoid any penalties under Section 409A. A 409A valuation that is unrealistically low can lead to penalties and tax consequences for both the company and its option holders.

Is 409A the same as fair market value?

The 409A valuation is conducted by a third-party appraiser to determine the fair market value (FMV) of a private company’s common stock for the purposes of complying with Section 409A of the Internal Revenue Code. A 409A valuation is an FMV at a point in time to ensure that stock options are issued at or above the FMV to avoid IRS penalties. The term “FMV” can also be used more broadly in other financial, legal, and business contexts to represent an asset’s or business’s value under market conditions.

What is the Difference between 409A Valuations and a Series A Valuation?

A 409A valuation is conducted to determine the fair market value of a company’s common stock for the purpose of setting the strike price of stock options in compliance with IRS regulations under Section 409A. It primarily affects how stock-based compensation is priced to avoid adverse tax consequences. In contrast, a Series A valuation occurs during a funding round, where investors determine the value of a company as a whole, including all shares and securities, to help decide on investment terms.

What is the difference between 409A valuation and post-money valuation?

A 409A valuation determines a company’s fair market value of its common stock primarily for the purpose of setting the exercise price of stock options, ensuring compliance with IRS rules under Section 409A. It is calculated by a third-party valuation provider for the private company. On the other hand, a post-money valuation refers to the total value of a company immediately after a financing round, including the amount of capital raised. It is calculated by adding the new investment received to the pre-money valuation of the company. This valuation is used by investors and companies to understand the new equity stake percentages and to reflect the company’s growth prospects and market conditions following the infusion of new capital.

Harness Can Help Optimize Your Startup Equity Taxes

If you’re a startup founder or employee with equity compensation, Harness can pair you with an experienced tax advisor who can help you make sense of it all. Navigating concepts, such as 409A valuations, can be complex, but we’re here to help.

Harness specializes in working with startup employees, founders, and other modern workers on unique long-term tax and financial planning strategies. By working with Harness, you get the support you need to make informed decisions about stock-based compensation. Sign up today to get started with Harness.

Tax related services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances.