Hey, it’s Scott Orn at Kruze Consulting, and today we’re talking about 409A valuation reports and why startups need them.
What is a 409A valuation report?
Startups use 409A valuations to price the options for their employees, and the valuation report is used to defend that price to the IRS. That’s right, the common strike price for employee stock options is determined by a 409A. And the IRS is involved because there are tax ramifications to the stock strike price, so the reason why people do that is so that there’s an independent third party that provides that valuation in the form of a 409A valuation report. That 3rd party helps prepare a 409A valuation report that you can share with the IRS to show how you reached the option pricing. That way the management team, or the board, isn’t figuring out what the strike price is - instead, you’ve got an independent, 3rd party valuation study/report.
One reason why you want to work with a quality accounting firm to do your 409A is because you want that 409A valuation report, and the option strike price, to be audit-proof. You don’t want to have to come back three or four years down the line after you’ve had a really successful company and have the auditors say, “Hey, that price is not accurate. That was too low, therefore we need to restate a bunch of options and it’s going to have major tax consequences for the company.” So doing it right the first time, making sure it’s audit-proof by an accredited partner, is incredibly important. That’s the whole point of the entire exercise and why you need a 409A valuation study.
How to see if you got the best 409A valuation report
As an executive of a startup, you shouldn’t have to be an expert at valuation reports or startup taxes. But there are a couple of simple tricks you can use to estimate if you have gotten a good startup 409A valuation report. Here they are, with some details below:
- 409A Backsolve method
- Cost to recreate method
- Discounted cash flow
Backsolve: One way that you can quickly estimate if you have a good 409A valuation is by backsolving. Compare the valuation of your last venture round, especially when it’s recent (this works best within the last six to nine months). Use the last round’s valuation and work backward from the price of the preferred stock or the SAFE note price.
Using the backsolve method, oftentimes the 409A common stock valuation on the price per share is about 25 to 35% of the preferred price per share. That means if your investors paid a dollar a share, it should be 25 cents to 35 cents per share for the common. If you were doing the work yourself using the backsolve method, you’d want to include some marketability discounts and other things but you’d get ultimately to that 25 to 35% range.
Cost to Recreate: You could do the cost-to-recreate method to see if you’ve gotten the best 409A valuation report. Create a spreadsheet that basically sums up how much it costs to build the technology, and also how much it costs to build the traction of the company. Say to yourself, “To recreate this company, we would have to spend X number of dollars.” That’s another way of quickly back-of-the-enveloping if you have gotten the best 409A report.
Discounted Cash Flow: Finally, another way checking to see if you’ve gotten a good study is to create a discounted cash flow analysis. Most executives are familiar with DCFs, but this could be tricky, as there are a lot of assumptions you might use to do this, and it’s open to a lot of interpretations. You’d need to use your startup’s financial model, estimate the capital raised to reach break-even, and do a DCF on the cash flows that you would produce. Picking the discount rate is always complicated.
Really, the easiest way for a startup executive to see if you’ve gotten a great 409A valuation report is to do the backsolve. It’s accurate enough, it’s fast, and it’s based off what a sophisticated investor paid for the company, and that means it has a lot of validity with auditors down the road.
What to look for when choosing a 409A valuation report provider
When choosing a 409A valuation provider, it is important to consider the following factors:
- Experience: Look for a provider with the required expertise and any relevant certifications who has worked with companies with similar business models. In our case, we recommend providers who know how to work with venture capital portfolio companies.
- Service: Choose vendors who are known for providing fast, efficient service and who come strongly recommended. Also make sure the vendor is willing to speak with you to determine your goals, so that they exercise can be tailored to your needs.
- Flexibility: Avoid vendors that are highly templated and that lack flexibility - not every company’s situation is the same, so just because your metrics are similar does not mean the valuation should be the same.
- Audit-readiness: The valuation report should be audit-ready and the provider should be able to stand with you in the event of an audit.
- Detailed reports: The report should be detailed and easy to understand, with clear explanations of how the final valuation was reached.
- Cost: some vendors are expensive, others are bundled with pricey software that you may not need. Choose a provider that offers the right price for the service you need.
Remember that the major reason for doing a 409A study is so that it’s audit-proof three or four years from now when you get an audit. You want to make sure that you don’t have to go back and restate anything. Make sure your provider is using assumptions tailored to your startup’s unique situation, and they are providing a 409A valuation report that you can use to defend your option strike price.
Talk with us about providing a quality startup 409A valuation report today!
Kruze offers 409A reports at attractive prices.
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