Granting equity or stock options is indeed one of the biggest moments for your startup. After all, it shows that your venture is all set to raise big-ticket capital and excel.

But before you can proceed with an equity offering, IRS regulations require you to get a 409A valuation. This is essentially meant to determine the Fair Market Value of your company’s stocks before you can issue them even partially. 

In fact, the IRS code for stock price valuation especially requires you to hire an independent 409A appraisal expert for this task. Now, as a startup owner, I am sure you have a lot of questions about 409A business valuation service, its scope, methodology, and utility. 

So read on as I’ve discussed everything that you need to know about these valuations, along with my appraisal tips. 

What is a 409A valuation? 

Before we discuss the nitty gritty of 409A valuations, it is essential you clearly understand what they are. 

To begin with, a 409A appraisal is a neutral third-party evaluation of your firm’s common stocks. And as we saw earlier, this is done to establish an FMV or Fair Market Value of these stocks. 

You see, the name 409A itself comes from Section 409A of the IRS Internal Revenue Code, which has set guidelines and benchmarks for these valuations. 

Herein, the idea is to ensure that there’s complete clarity about the market value of your firm’s equities. This, in turn, will remove conflicts of interest and offer credibility as you offer equities to your company’s employees, independent directors, etc. 

Moreover, the IRS has even specified severe penalties for failing to get a 409A appraisal before an IPO, direct listing, or private placement. In all, a 409A appraisal is a necessary independent analysis of stock value before the first stock offering. 

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Who needs 409A valuations? 

While 409A evaluations are useful for all companies, notwithstanding their size, it’s mostly startups or early-stage ventures that need one. That’s because most startups, especially in their initial stages, aren’t publicly listed, which means that there isn’t reliable information about their equity value. 

So, if you’re a startup founder/owner planning on offering stock options, a 409A appraisal is the best way to know independent estimates about your stock’s worth. 

Similarly, if you’re in the process of rolling out equity grants, you’ll need one such valuation. In fact, a 409A stock valuation and fair price offering is the only way to prevent both shareholders and the company from being penalized by the IRS. 

Why do you need a 409A valuation for startup? 

As we just saw, the fact that startups aren’t traded on the public stock exchanges means the fair market worth isn’t publicly known. And this is exactly where chances of foul play emerge, where owners tend to offer their common stocks to their employees at a much lower price. 

Now, the Internal Revenue Code Section 409A clearly states that the price of your common stock can not be lower than its Fair Market Value. 

And to determine the Fair Market Value of the common stocks, the IRS/IRC regulations require a “reasonable method” involving independent appraisers. Herein, a third-party valuation expert will calculate the FMV of the stocks at the time of the equity grant and every 12 months thereafter. 

The idea is to create a “safe harbor” for your company where the IRS holds the price of the common stock to be valid. 

When do you need 409A valuations? 

When it comes to 409A appraisals, you might assume that they’re only needed at the time of the common stock offering. 

But is that the only time you need these valuations? 

Certainly not. You see, the Fair Market Value of your company’s stocks can come in handy for a lot of purposes. And this includes: 

• Offering stock options to your company’s employees for the first time (common stock). 
• After every 12 months of each valuation. 
• Raising capital for your company by offering its equity to financers (venture financing). 
• If there is a material event such as a new partnership, change in IRS or other laws, etc.
• When you’re planning to go public by offering an IPO. 

How often do you need a 409A appraisal? 

The Internal Revenue Code has specified a 12-month validity of a 409A stock valuation from the date of the appraisal. 

Meaning, after the first valuation at the time of the equity offering, you’ll need subsequent valuations every 12 months. This will keep the stock value relevant and ensure your company remains in the safe harbor. 

However, you may need a valuation even before the 12-month timeline if a material event arises. 

For instance, in order to raise capital for your startup, you might decide on selling shares or offering equity to financers. And in such an event, you’ll need to know the Fair Market Value of your company’s stocks. 

You might also want to read – How To Get Rid Of A 50 50 Business Partner. 

409A valuation: How is it calculated? 

Now that you know what a 409A appraisal exactly is and when you might need one for your startup, you might be curious how it’s calculated. 

And rightly so, as the calculation method will influence the final stock FMV. In fact, depending on the method of calculation, the FMV can be either higher or lower, which will further impact the stock offering. 

Well, a 409A appraisal is a complex exercise, given the numerous methodologies available and the different results each method offers. 

Nevertheless, the entire valuation process can be broadly divided into three steps: 

Step 1. Determine the enterprise value or the total fair market value of your company. 

Step 2. Estimate the fair market value of the company’s common stock.

Step 3. Apply DLOM or discount for lack of marketability. 

Not sure how these steps work? 

I’ve explained each of the steps in detail. So, read on to find out how you can calculate the FMV of common stocks using a 409A appraisal. 

Step 1. Determining the enterprise value (EV)

Basic as it might seem, establishing an accurate enterprise value or the total Fair Market Value of your company is an essential step in 409A appraisals. 

For starters, this involves a simple business valuation using the three main valuation methods, namely income, market, and asset methods. And depending on the valuation method that you opt for, the enterprise value and the subsequent 409A stock valuation will differ. 

So, it is essential you first understand your business’s strengths and weaknesses and go for a method that suits your interests.  Now, let’s have a brief look at the various valuation methods and see how they work. 

A. Income method 

The income or earnings method is one of the most commonly used methods for calculating the enterprise value of a startup. It looks at the most recent cash flow and earnings statistics of your company while also accounting for future earnings potential. 

As such, this method offers a reliable valuation for your business based on current earnings. Talking about startups, this method can be beneficial if you have a decent cash flow. Also, the fact that the method assesses future income potential can provide you with a favorable valuation since early-stage companies have a high growth potential. 

B. Market method

The market method utilizes data from companies that are of a similar size as yours and operate in the same industry. Herein, an appraiser will analyze the similar-sized businesses that have recently sold to arrive at an enterprise value for your company. 

This method is particularly beneficial for startups such as restaurants, fast food chains, gym chains, etc. That’s because market data for similar-sized companies are readily available in these industries. 

C. Asset method

As the name suggests, the asset method calculates the value of all the assets of your company. And this includes everything from office property to electronics to furniture to patents and copyrights. 

In this method, a business appraiser will add the total value of all assets and subtract the value of liabilities, such as debt, NPAs, etc., from it. The resultant value will thus be the total enterprise value of your company. 

Now, I don’t suggest early-stage companies go for this method because the number of assets they own is usually less compared to old businesses. However, if your business is incurring losses at the moment, then you can definitely go for this method over others. 

Wondering what’s more to these methods? 

You can go through my blog – The Ultimate Business Valuation Methods Guide. 

Step 2. Establish the Fair Market Value of common stock 

Next up in the 409A valuation, a startup will need to establish the FMV or Fair Market Value of its common stock. 

While there’s a simple formula for calculating stock FMV, i.e., dividing the enterprise value by the outstanding of diluted shares, it isn’t as simple in practice. That’s because companies have different classes of equity, and applying a one-size-fits-all approach to all equities will not result in a fair stock valuation.

So, depending on the type of equity, there are two common methods that you can use to determine the FMV of common stocks, namely: 

A. Current value method 

For startups in their earliest stages, the current value method is a reliable way to establish the FMV of common stocks. Herein, a business appraiser like myself will take into account the current-day value of the equity. 

For instance, I’ll likely assume that there is an upcoming sale of the company. This will allow me to discount the likely future value of stocks and stick to contemporary estimates. 

Thereafter, I will allocate FMV across different classes of equity based on conversion ratios, participation rights in future financing, etc. 

B. Option pricing method 

Like the previous method, option pricing is also an ideal approach for startups in their earliest stages. 

However, unlike the current value, I’ll treat equities across classes as call options. Now, this will provide different price determination methods for various stock classes.

For instance, the exercise price of preferred stocks will be determined by liquidation preference. Similarly, for common stocks, the FMV will be determined by the amount left over at the end of liquidation preference. 

Note: Apart from these FMV calculation methods, there are two more methods, namely: 

1. Probability-weighted expected return method – Used for mature startups, especially those looking to go public. 
2. Hybrid method – Uses a mix of option pricing and expected return calculations and is apt for companies eyeing M&As. 

Step 3. Apply DLOM or discount for lack of marketability

The final step in a 409A appraisal, this involves discounting the FMV of your company’s common stocks for lack of marketability. 

The idea behind this step is pretty straightforward: There isn’t an active market to trade your firm’s common stocks, and unlike the publicly traded stocks, your employees can’t sell these in the open market. And this means the value of these stocks is lesser compared to those trading openly. 

So how do you apply this discount? 

Well, there’s a basic calculation for applying a DLOM or discount for lack of marketability. Herein, an appraiser looks at the present performance of your firm and calculates a success ratio for the future. 

For instance, if you have a high cash flow and all the statistics point to success in the near future, this is a sign of higher marketability. As such, the rate of discount applied to common stock FMV will be lower. 

Curious if your CPA can do a 409A appraisal for your company. 

You can go through my blog – Can A CPA Do A Business Valuation? 

409A valuation: Frequently asked questions 

What is the IRC Section 409A? 

The IRC or Internal Revenue Code section 409A provides the legal framework for 409A appraisal to determine the Fair Market Value of common stock options. It was enacted in 2005 in response to the Enron Scandal of 2001 and went into effect in 2009. 

You see, back in 2000, many senior executives of Enron Corp., a leading energy company, siphoned $32 million from deferred compensation accounts. And this amount was then moved into limited partnerships or LPs they had created for their family members. 

As a result, the creditors couldn’t recover the assets when the company went bankrupt, and the employees lost over two-thirds of their savings. 

Section 409A of the IRC created a rigid legal system to prevent companies from manipulating their common stock prices. And the requirement to hire an independent 409A appraiser is one of its major clauses that ensures impartial stock valuations. 

How much does a 409A valuation cost for startups? 

As per estimates from Eqvista, you can expect to pay between $1000 and $5000 if you own a small to medium-sized startup. 

However, there isn’t a fixed price range for these valuations, and the actual amount you pay can be higher. In fact, if you own a large company, you can expect the 409a valuation price to be upward of $10,000. 

What is a safe harbor in 409A valuations? 

A 409A valuation safe harbor involves the FMV of a common stock calculated by an independent appraiser, which the IRS holds reasonable. 

For instance, if you’ve received a 409A appraisal from a third-party appraiser, the FMV of your common stock options will be eligible for ‘safe harbor.’

In simple words, if you have a safe harbor status, you can legally offer common stocks at a certain FMV. And you can continue to do so until the IRS can substantially prove that the stock valuation is unreasonable. 

What is a material event in 409A valuations? 

A material event is any significant event that has happened within your company that requires a new 409A appraisal, even if the existing valuation has not expired. 

Here are some situations that can be considered as a material event: 

• A business deal involving partial or complete merger and acquisition. 
• A major partnership that is likely to open new and major revenue streams. 
• A new contract that is set to change your company’s ARR or annual recurring revenue. 
• A change in IRS/IRC or other relevant government regulations that affects your overall business. 

Discover Your 409A Valuation Today!

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What is a 409A refresh? 

A 409A refresh is simply the new or updated appraisal that your firm will need either after 12 months of the existing appraisal or after a material event. 

As we discussed earlier, 409A valuations are required after every 12 months since the existing valuation expires. Similarly, a material event like the ones discussed above can require a fresh valuation. 

So, a 409A refresh is a formal term for the recurring valuations that you might need in different situations. 

What is a 409A penalty? 

A 409A penalty is a monetary penalty imposed by the IRS in two situations: 

1. You proceed with a common stock offering without a safe harbor status. 
2. The IRS proves with evidence that the FMV valuation is unreasonable. 

In both these cases, the deferred compensation to your employees for both the current and previous year will become taxable. Also, the compensation will be subject to a 20 additional percent tax penalty. Own a landscaping startup that you want to evaluate.

You can go through my blog – How To Value A Landscaping Business For Sale?

Conclusion 

As you can see, a 409A valuation is an essential legal step that you’ve to follow before offering common stock and every 12 months thereafter. 

But even though it might seem tedious and unworthy, it is actually beneficial for startups. After all, it can safeguard your business from IRS scrutiny and penalties, guaranteeing complete peace of mind.  

Looking for a 409a valuation for your startup? 

At Arrowfish Consulting, we’re seasoned third-party business appraisers. And our 409a valuation services are tailored particularly for startups like yours. So get in touch with us today and receive a free quote for your valuation project.

Jeremiah Grant

Jeremiah Grant is the Managing Partner of Arrowfish Consulting. In addition to acting as a primary liaison for many of the firm’s engagements, He primarily focuses on business valuation and economic damages expert witness assignments, in addition to forensic accounting and insurance claims analysis.

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