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.
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:
Ask the provider if they are working off of the preferred share price, especially if you recently closed a venture capital round. They 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 team. 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.
We can help provide a second opinion if you are worried about too high of a common stock price. Contact us now.
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.
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.
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.
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.
We can help you through every step of the process: from understanding key terms to getting the best deal.*
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.
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.
Upon conclusion of our findings, you will receive a 30+ page in depth 409A report that is readily shareable with your investors and Board.
Unless there are significant changes like a new investment round.
Our economies of scale bring the cost down without compromising quality.
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