The IRS requires non-public companies that offer stock based compensation to their employees (i.e. venture capital backed startups) to conduct a 409A valuation of the company’s stock. This determines the fair market value of the company’s stock, and is used to set the strike price for employee options.
When you are running a startup, the last thing you want to worry about is what seems like government paperwork. We get that. Unfortunately, the IRS wants your startup to have a 409A valuation so they can make sure that your common stock options have the appropriate strike price. Your employees common stock options are worth something - the 409A helps the IRS compute that worth for tax purposes.
Years ago the board of directors used to just make up a number for the strike price for options. Oftentimes that was usually one penny - because it’s the simplest thing to do, and it’s pretty employee friendly (who doesn’t want a super cheap strike price on their options?!) But the IRS realized that that usually wasn’t representative of the real value or price per share of those options, and so they started mandating that companies opine on the exercise price by doing an academic exercise called the 409A.
When you hire a firm to conduct this work, what you are really paying for is audit protection. You’re making sure that you have an independent, third-party, place a value on your company/value the common stock with the standard documentation that the IRS wants to see.
If you plan to offer equity to employees, you’ll need a 409A valuation. The IRS requires private companies to report how much they pay for stock options when they’re granted or transferred, and improperly valuing stock options can create substantial penalties. The main reason for working with a reputable third-party company is to make sure your 409A is audit-proof. You need to use a valuation firm that has experience producing 409A valuation reports and understand their complexities, so you can be sure your report is accurate and complies with all IRS regulations. Your 409A provider will provide you with a summary of their findings, and detailed breakdowns of the methods used to calculate your startup’s value. Those methods could include things like backsolving, comparing your startup to similar companies, analyzing your income, or totalling your assets. Not every method is appropriate for every startup, so your report will explain the methods used to you (and the IRS).
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.
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:
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.
We can help provide a second opinion if you are worried about too high of a common stock price. Contact us now.
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.
This is a very common question from founders, but basically, the answer is: no, venture capitalists will not use a 409A valuation to value a startup.
Investors will rarely even talk about the 409A price except to approve it in a board meeting. They know that they are buying preferred stock, and not common stock. And preferred has liquidation preferences, redemption provisions, and share class vote, which gives them a really strong ability to control the company. There’s also dividends and many other things in preferred stock that are better terms than common stock.
So VC’s know that they are always going to pay up and pay a higher valuation for the preferred stock and that’s really what the round gets priced on.
Now, if you do have a venture capitalist who’s using a 409A price, you need to get a new venture capitalist, so don’t sign that term sheet. Go find someone else.
But again, VC’s are very savvy. They know that the 409A is not to be used against a founder and that the company effectively wants those prices to be low. So, don’t worry about it.
Get the 409A valuation. Send your conservative financials to your valuation provider. Make sure you pick the comparable companies that are good matches, but also conservative. You may even do a cost to recreate for the valuation provider. That will set you up, you’ll get your accurate price.
And you’re not going to have to worry about your VC negotiating against you using that 409A price.
Startups should conduct a 409A valuation after every priced round, or at least annually if there has been no recent priced round.
The IRS requires startups to get 409A valuations after every priced round, or annually, which ever is more frequent. A 409A is not required when a company is first formed and founders shares are distributed to founders.
The IRS instituted 409A valuations to address the fact that startup boards were underpricing their stock options. Typically startups would price each share at a penny instead of the fair market value, so management would exorcise their options and pay only a penny a share.
As the stocks increased in value, the management team would only pay the capital gains tax of 20%, rather than the income tax rate, which is closer to 35-40%. The IRS closed that loophole by requiring companies to get a 409A valuation from a third-party accredited valuation provider to avoid underpricing stock options. Now startups need a new 409A valuation every 12 months or each time there is a material change in the company’s valuation.
Answering the specific question we get a lot:
A startup needs a 409A valuation after every priced round, or at least annually if there has been no recent priced round. It is also required when there is a material change in the company’s valuation. However, a 409A valuation is not required when a company is first formed and founders shares are distributed to founders.
Many valuation providers will use the back-solve method to do a 409A valuation. This means they work backward from your preferred valuation and apply discounts because a preferred stock has liquidation preferences and redemption rights and dividend provisions, and you can control the big decisions with a share class vote. There’s a lot of value in preferred stock versus common stock. Therefore, the common stock trades at a significant discount.
Now, if your company has never done a round with the valuation, hasn’t done one in a very long time, or maybe you’ve done a convertible note or safe note with no implied valuation in the form of a cap, then what do you do?
You can’t use the back-solve method. This is when it comes to the cost to recreate.
The cost to recreate is basically “how much would this company have to spend to rebuild or recreate all the technology that they have built to date?”. It is the closest you can get to a perfect valuation here.
So to build the cost to recreate, you are going to go through all your expenses over time and calculate them. You are essentially capturing the income statement: all the salaries, contractor payments, software tools … anything that went into building your product is going to need to be itemized and submitted to your valuation partner.
Don’t forget the balance sheet. Oftentimes companies will buy big capital expenditures, like big machines or things such as that. That also needs to be included in the cost to recreate. It is important to even go a step farther on a balance sheet item, which is the prepaid expenses. If your company has signed many licenses from software providers or tool providers they should be included, even though some of them are capitalized on the balance sheet.
So once you get all these expenses from the life of the company tabulated, hand those over to your valuation partner. Once you get that valuation back from your partner, you will be able to price all your employees’ stock options. They will be happy, you’ll be happy and you’ll be all set.
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.
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.
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:
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.
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.
In 2022 we’re facing a pretty big correction in the overall stock market. That means that the comparable company valuations (comps) for venture capital investing are not increasing like they have in the past. These older valuations are making it harder to fundraise. Even if your company has made a lot of progress since the last fundraising round, VC firms have to take a very close look at your valuations based on the current economic environment. So you may not receive the funding you had hoped to get at this point. However, if you need the extra capital, you should probably take the money.
Yes, they can. This typically happens if there is a subsequent VC investment at a lower valuation; for example if the Series C stock price is lower than the Series B. However, it is also possible for a startup to lower it’s valuation even if there hasn’t been any outside, professional investment group investing at a lower stock price. For example, Instacart has somewhat famously cut its valuation three times. In March of 2022, Instacart cut it’s valuation by ~40% to $24 billion, then in July 2022 it reduced it to $15 billion, and then in October it reduced it to $13 billion. So it is possible for a startup to get a lower 409a even without a massive, outside VC investment at a lower stock price. However, it is still rather rare.
In 2022, public technology stocks have corrected significantly, and they’re down about 50%. That, in turn, is beginning to affect the 409A valuations of late-stage companies that aren’t publicly traded yet. Many 409A valuations use a “market approach,” which means the company is compared to several similar companies that are publicly traded. Then some other valuation multiples are applied to reach an enterprise value. So some late-stage companies are bringing their common stock valuations, which are driven by the 409A valuation, down.
We can help you through every step of the process: from understanding key terms to getting the best deal.*
TOP 409 FIRMS
Our valuation partners have the highest certifications and designations and perform over 150 409A valuations per month. They are former Big 4 valuation partners and investment bankers from top firms. No work is done offshore.
We apply valuation methodologies and assumptions that are specifically tailored to your unique situation. The valuation methodology follows AICPA and USAPAP guidelines closely making the reports audit ready.
COMPLETED IN 10 BUSINESS DAYS
Valuations are completed 10 Business Days from the date that all company information is submitted. For Kruze clients, that’s easy because we already have your info in our systems.
IN DEPTH REPORT
Upon conclusion of our findings, you will receive a 30+ page in depth 409A report that is readily shareable with your investors and Board.
VALID FOR 12 MONTHS
Unless there are significant changes like a new investment round.
Our economies of scale bring the cost down without compromising quality.
Kruze Consulting, Inc.
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