409A Valuation for Startups

Generally speaking, a 409A valuation should take about 10 business days. Of course, the process can’t begin until you’ve submitted all your information, which includes your capitalization table, your financials, and your legal documentation.

409A valuations only last for 12 months, or until there is a material event in your company that changes its valuation. Usually, that’s because you raised a round and your valuation has changed. It’s best to have 409As done regularly, because the stock options you issue to your employees depend on that valuation to set a strike price.

What can you do if your 409A valuation is too high?

There is a very systemic problem in the startup world with valuations coming in too high, and the reason for that is 409A providers are heavily scrutinized by two groups. The first are the valuation accreditation entities. These bodies audit and analyze the work of the valuation providers to make sure they’re doing everything in compliance with the current, accepted methodologies. The second is the IRS. The IRS really wants these valuations to be fair - as in, not too low - because if they’re too low, a bigger percentage of the taxes paid by employees when your startup exit happens come as capital gains taxes, which have a lower tax rate. So the valuation firms are under a lot of pressure, and face possible liability, if they don’t come up with a justifiable number.

Overly high valuations are becoming more and more common, because this pressure from the IRS and accreditation entities ends up pushing the valuation people to be more conservative, and more conservative in valuations means a higher valuation. It means that your company, on paper, even though you probably haven’t accomplished a ton yet because you’re still a startup, is going to have a much, much higher valuation. That hurts your employees, and may make it harder for you to hire the best talent. There are ways to get a better outcome. In particular, so much of a valuation comes down the unique circumstances facing an individual startup. That diligence can influence a number of the equations and assumptions, and can help your company reach a more reasonable outcome. Here are some of the tactics you can use if you feel that your current provider is coming in too high:

• Ask the provider if they are working off of the preferred share price, especially if you recently closed a venture capital round. The firm may be using the “backsolve method,” which basically means that they are working backward off of the preferred stock price to compute the common stock price. However, the VC investors may have a whole slew of rights and privileges associated with the preferred that the common does not have. Those rights, especially if there is a liquidation preference - make the preferred stock worth a whole lot more than the common shares.
• Secondly, make sure you give appropriately conservative financials to the valuation firm. The pie in the sky financials that you used to woo the VCs may be too aggressive. If you think that there is any chance that you are unlikely to hit those numbers, then you should offer up a more realistic, conservative case. You can offer projections that are both honest and conservative. One thing to try is to make it take longer for you to hit your big, out-year, $100 million revenue number, for example. We find that this usually takes longer than people project, so you can do this honestly.
• The third thing you want to do is make sure you pick your comparable companies intelligently. If you are a hardware company, don’t use Google as a comparable. Stay away from the super hot IPOs, as those are usually overly valued.

The right ratio should be around 25 to 35% of common to preferred, meaning if preferred is $1, you want common to be somewhere around 25 cents, 30 cents. If it’s too much higher than that, you have a right to ask your provider for more information.

Is a lower 409A better?

A lower valuation helps startup founders attract and retain employees, since it gives the startup’s employees a lower strike price on their options. In theory, this means that employees will have a larger spread between their option strike price and the stock price at an exit, therefore the employee would earn more at the exit.

If your startup’s valuation is too high, it’s best to reset it and get it to a more correct value. An excessively high valuation is going to affect your decisions. Startups with overly high valuations may not invest in the company because you’re trying to protect that valuation. So get the valuation reset, even though that’s probably going to dilute everyone’s shares.

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An overpriced 409A valuation could be detrimental to your startup, and the reason for it happening is a common mistake we see founders making. Your 409A is a valuation of your startup that you get from a third-party accredited valuation provider. It sets the strike price for your common stock options for the employees at your company.

There’s a lot wrapped up in the 409A valuation because employees want a fair strike price for their options and you want to have motivated employees. Therefore, you don’t want to overprice it by accident. And presenting an overly ambitious 409A model could lead to a higher strike price.

Don’t Use the Same Financial Model for VC pitches and 409A

Here at Kruze, we see a lot of founders frequently using the same financial model for their 409A as they used for their venture capital pitch deck. This can cause problems because everyone knows (especially every VC) that when founders are giving them a financial model they are doing so in “sales mode.” Their number one aim is to close a round. The projections are designed to help sell how big the business can be, not to super accurately forecast what the near term results will look like.

Founders want to convince the VC that their company is the greatest startup in the history of mankind, meaning their projections are going to be extremely aggressive. Venture capitals know this. They will actually discount those projections quite heavily most of the time without even telling the founders. Typically they will do that in internal meetings when they are trying to gauge a realistic trajectory for the company.

Develop A Realistic Financial Projection for the 409A

If a founder turns around and gives the exact same aggressive model to the third-party 409A provider, the provider does not have the leeway to discount the “sales mode” projections. Third-party 409A providers have to take what you give them and use that exact financial model when formulating your 409A price. By giving them overly ambitious projections, you will end up with an abnormally high valuation and, subsequently, an overpriced strike price for your employees.

You need to remember you are dealing with a different entity from a venture capital fund. Therefore, you need a different approach:

• Take your time!
• Develop a more conservative version of your financial model.
• Present your more realistic financial model to your 409A provider.

That will help you get a 409A valuation which is both realistic and ensures your employees are happy with the strike price for common stock.

An Accurate 409A Is Important to Your Startup

Remember, 409A providers cannot form their own opinion on your financial models like VCs can. They are regulated by the accreditation bodies who have to ultimately report to the IRS. They are going to be very careful. And you’re going to need to repeat the 409A valuation process regularly, so it’s important to get it right.

It’s possible but not common. Typically the 409A valuation is about 35% of the preferred valuation, and VCs are receiving preferred stock. So normally the 409A valuation should be lower. The only exceptions, and these are rare, would be if a company did a downround and had not updated its 409A valuation in a while. The other possible exception is if the company is doing very, very well and hasn’t needed to raise money in a while. So the current 409A valuation could be higher than the last VC valuation, but it depends on not having needed to raise funds for a while.

While a 409A valuation sets a fair market value (FMV) for a startup’s common stock, a post-money valuation takes all of the shares in startup and multiplies them by the price VCs paid to purchase shares in the most recent funding round. That gives a startup’s estimated value after receiving new funding, and lets investors see what their ownership stake in the company is.

The backsolve method for 409A valuations uses a recent stock transaction, like a preferred stock financing, to determine the fair market value (FMV) of a startup’s common stock. By using the known price of the preferred shares, this valuation method applies option pricing models or other valuation techniques to allocate the company’s total equity value between the different classes of shares. The backsolve method is particularly useful for startups, where the value of common stock can be difficult to assess due to limited market data.

SAFEs are becoming more popular for financing startups at early stages, and how much it affects your valuation is a bit of a gray area. However, you should probably get a new 409A if you’ve gotten a SAFE. Any new investment is probably going to change the value of your startup since it’s going to be invested in growing the company. So it’s best to be conservative and get a new 409A.

One of the important considerations in creating a 409A valuation for a startup is what other companies that similar to the startup in size and company stage are worth. We’ve seen some dramatic shifts in startup valuations over the last few years, and the trends we’re tracking in 2024 may impact your startup’s valuation.