409A valuations are used to appraise the fair market value of startup stock
As a founder, the board of directors at your startup will have a statutory obligation to only offer shares or stock options to employees and advisors at what is known as “fair market value”. One way of determining a fair price per share for your startup’s common shares is by getting an external valuation service to provide a valuation for the company and complete what is known as a 409A valuation.
409A valuations get their name from section 409A of the Internal Revenue Code (IRC). To understand why startups must complete a 409A valuation, it’s useful to start with why this section was added to the IRC as part of the American Jobs Creation Act of 2004.
The origin story of the 409A valuation
Let’s go back a couple decades to the days of the first tech bubble, the late 90s. Google had just raised a $1M seed round from Ram Shriram, Jeff Bezos and a number of other prominent angel investors. Shortly thereafter, the company issued stock options to its first employees. How would the fair market value of Google’s common stock have been determined? At the time, the norm established by lawyers and investors was to use a simple rule for calculating common share price: 10% the last price per share paid by investors. So, if a company sold shares in a priced round at $5 per share, the fair market value of common shares would be $0.50 per share.
Today, this is not how we calculate the fair market value of common shares. A rough estimation was used for FMV back in the 90s because the rules were not rigorously defined. In fact, many parts of the Internal Revenue Code (IRC) regarding stock options were not fully fleshed out at that point in time.
Because of the lack of clarity in the law, that left some loopholes that could be exploited. Enron exploited those loopholes in 2001. Prior to filing for bankruptcy, Enron executives were granted large options to purchase the company’s stock under the company’s deferred compensation plans. Then, the company’s executives accelerated payments to themselves under their deferred compensation plans to pay for the option grants. This allowed the executives to get access to the company’s operating capital and get paid out before the company went bankrupt.
Typically in bankruptcy proceedings, there is a standard order of operations for payout. First, the employees are paid any wages they are owed, then the government is paid any taxes owed by the company, then, finally, shareholders can be paid out from funds left over from the sale of company assets. What the Enron executives did was to effectively jump the line through the use of stock option grants in the company’s deferred compensation plan. When Enron officially filed for bankruptcy on December 2nd, 2001, it was painstakingly obvious that the loopholes around stock options and company valuations had been exploited by Enron’s leadership to enrich top executives.
The US government responded by regulating the stock option loopholes in the tax code. While Enron was the most well-known abuse of these loopholes, it was far from the only company taking advantage of the lax rules around stock option valuation. In the summer of 2004, the American Jobs Creation Act was passed, including Section 409A of the Internal Revenue Code. This section in the IRS tax code was created to prevent payment-acceleration practices such as those that the Enron executives had abused.
Section 409A addresses those loopholes in a few ways, but the most important change enacted was to create a very strict valuation definition for common shares and options. The old rule of “take 10% of the preferred share price” could no longer be used like it was in 1998.
The wording of the law spells out penalties for non-compliance (more on that below), but also carves out an exception for shares and stock options granted at the stock’s fair market value. If a company issues stock at a valuation below the fair market value of the shares, the penalties in section 409A will apply. To put it in simple terms: if your startups gives your employees the option to purchase a share of stock that is worth $1.00 per share, the only way to avoid the penalties spelled out in section 409A is to make sure that the employee’s strike price is exactly $1.00 per share — and under no circumstances, should the share price be even a fraction of a cent lower.
When do startups need to get a 409A valuation?
Startups typically get a 409A valuation after raising their first priced round and issuing preferred stock to investors. There are “material events” that can trigger the need for obtaining a 409A valuation for your startup, such as:
- A qualified financing, namely the sale of common shares, preferred stock or convertible debt to outside investors
- Outside of financings, other material events include mergers, acquisitions, secondary sales of common stock, business model pivots and major changes to financial projections
Internal Revenue Code 409A valuations are valid for up to 12 months after going into effect. If a “material event” arises before the 12 months are up, your company will need to seek a new 409a valuation.
What are the 409A safe harbor presumptions?
A safe harbor valuation is a valuation the IRS presumes to be valid… unless the IRS thinks that the valuation can be shown to be “grossly unreasonable.” The legal code in IRC 409A spells out three presumptions through which you can get a 409A valuation for your startup: the binding formula presumption, the illiquid startup presumption and the independent appraisal presumption.
- The Binding Formula Safe Harbor Presumption. The binding formula presumption is not typically used by early-stage startups. This rule applies only to 409A valuation based on the consistent use of a standardized repurchase formula in the company’s stock transfers. The legal language specifying where this presumption can be applied is rather complex and convoluted.
- The Illiquid Startup Safe Harbor Presumption. The illiquid startup presumption to safe harbor 409A valuations is specifically designed to accommodate startups. This presumption only applies in cases where the company does not anticipate an IPO within 180 days or a change of control, such as the acquisition of the company, in the next 90 days. To make use of the illiquid startup presumption, the 409A valuation must be completed by a “qualified individual”, which, according to the IRS definition, is a person with the relevant knowledge, education and experience to complete an outside appraisal of the company.
- The Independent Appraisal Safe Harbor Presumption. The independent appraisal presumption is the safe harbor presumption most frequently used by startups. The IRS wants startups to obtain 409A valuations from reputable firms that employ consistent and document methodologies when performing appraisals.
How much does a 409A valuation cost?
409A valuation providers differ widely in cost, from $1,000 to over $10,000, depending on the number of shareholders, the classes of shares in the company, as well as the company’s finances and business model.
At Capbase, we’ve partnered with independent & trusted valuation partners to offer discounted 409A valuations for our customers. Getting a 409A valuation from an independent partner is essential to maintaining your startup’s safe harbor under section 409A of the Internal Revenue Code.
Often, when a company fails to achieve a safe harbor appraisal from the IRS, the cause is because the valuation was not performed by an independent firm. Many startups choose to obtain 409A valuations offered directly through their cap table software provider. Before deciding to go down this path, make sure to investigate the independence of the 409A valuation provider. Otherwise, this could jeopardize the independence of the valuation you receive.
Risks of getting an improper 409A valuation
If your 409A valuation isn’t performed using one of the approved methods, the IRS may hand out substantial penalties to the company as well as its shareholders and employees.
- All deferred compensation (the value of all option grants awarded to employees) from the current and preceding years becomes taxable immediately
- Accrued interest on the revised taxable amount must be paid
- An additional tax of 20 percent will be assessed on all deferred compensation
The IRS is not playing games when it comes to compliance with the rules around 409A valuations. The penalties could ruin your employees finances and prove fatal for your startup.
What data do I need to provide to get a 409A valuation for my startup?
To complete your 409A valuation, the appraiser will need to obtain information from you about your company and its finances.
- Name of company directors and officers
- Name of the company’s legal counsel
- The company’s articles of incorporation, including any amended versions authorizing the issuance of preferred stock
- Information about the startup’s industry and business model
- A list of related companies that are publicly traded; many 409A valuations will make use of a comparison to publicly traded companies
- Details about the company’s fundraising history, including any convertible notes, SAFEs, preferred stock issuance and venture debt
- Plans for future liquidity events such as an IPO or an acquisition
- Company financial statements and books
- Forecasted revenue for the next 12 to 24 months
- Burn rate and runway
What are the most common methodologies used in 409A valuations?
The independent appraiser that is completing your company’s 409A valuation has an obligation to ensure that their method for calculating FMV is based on a defensible methodology. The three standard methodologies for calculating FMV in a 409A valuation are the market approach, the income approach and the asset approach.
- Market approach (or OPM backsolve). When your startup raises a priced round, 409A valuation providers will typically use the market approach method to calculate the FMV of your common shares. The most basic formulation of this valuation methodology is to assume that new investors paid market value for the preferred shares in the financing round, then to adjust this price down to determine the FMV for common stock. Other market-based approaches use the company’s financial statements, including revenue, net income and other accounting details to estimate the value of the startup’s common shares.
- Income approach. For startups that are cash flow positive and have sufficient revenue, valuation providers can opt to use a straightforward income approach. This valuation methodology defines the company’s fair market value as its total assets minus its corresponding liabilities.
- Asset approach. This valuation methodology is used for early-stage companies that haven’t raised any money from outside investors and have not generated any revenue. To calculate the company’s FMV price using this approach, you simply have to calculate the company’s net assets.
- A startup’s board is in the hook for ensuring that the company only offers equity to employees at fair market value
- Startups should use an independent, outside valuation firm to get a 409A valuation before offering stock options to employees to avoid fines and legal issues with the IRS
- 409A valuations get their name from the section number 409 of the Internal Revenue Code, which went into effect on January 1, 2005
- The law mandating 409A valuations was enacted, in part, in response to financial malpractice by executives at Enron
- 3 common valuation methods for 409A valuations are the market approach (OPM backsolve), income approach and asset approach