Most founders dream about getting their product live and solving real-world problems. Something you're probably not dreaming about? 409A valuations.
Getting a proper (and founder-friendly) 409A is a problem you will need to solve. This post will explain the 409A process and give you an idea of what to expect from a 409A.
1. What is a 409A valuation and how do they work?
First, it is important to distinguish between a 409A and a valuation set by investors during fundraising.
A 409A is used to determine the fair market value (FMV) of your company and is set by a 3rd party valuation service. The 409A is regulated by the IRS (you can read more here) - 409As set the strike price for common shares (awarded to employees, advisors, etc.) and ensure that options represent their real value. The IRS requires a 409A valuation for companies to maintain their safe harbor status.
A 409A valuation is often (but not always) different from the post-money valuation of your company after fundraising. This is because investors are getting preferred stock, which might be valued higher than common stock due to better liquidation preferences.
While it is possible to run your own financial analysis to determine your FMV very, very early on in the lifecycle of your company, it's almost never worth it because valuations are difficult and take a lot of time. Additionally, third-party, independent valuation providers establish safe harbor status and prevent the onerous IRS penalties that can be levied on common shareholders if a company's FMV was not appropriately determined.
2. What is safe harbor?
Safe harbor means that your company has completed an acceptable 409A valuation in the last twelve months and is thus protected from having to prove to the IRS that the FMV is accurate. Over 99% of the time this valuation is performed by a third-party. In some rare cases (like if you’re an illiquid company, under 10 years old) you can gain safe harbor from having an internal employee with adequate accounting experience do the valuation (we rarely, if ever, see companies choose this option).
What happens if you don’t have safe harbor, the IRS audits you, and the options you issued most recently are deemed not to be properly set at a fair market value?
In this situation, employees who received options at the incorrect price will be taxed on those options immediately, will be fined an additional 20% of the value, and will have to pay other penalties. This is a significant financial burden to employees who should have been protected by a more knowledgeable and responsible founder.
3. When to get a 409A valuation
As a startup founder, you need to figure out the timing of when to get your first 409A and then your subsequent valuations. Here are some rules to follow:
A new normal: The world of 409As has changed dramatically. 409As used to be the sole domain of expensive valuation firms that would charge anywhere from $5,000 to $25,000 to complete a valuation. The same way sites like LegalZoom upended the legal market, Carta has used technology and scale to dramatically reduce the cost of valuations. Now, 409As are affordable, even for companies with less than ten employees (learn more about Carta's 409A process here). Want even more info? Check out Jose Ancer’s post on 409As as a Service.
Guidelines on when to get a 409A:
- Generally, you should get your first valuation before you issue your first common stock options (typically to your first hire or advisor)
- You should get a new 409A valuation after raising a round of venture financing, as the previous 409A becomes obsolete once the new round is raised
- Once your company is more mature (greater than ten employees/post-Series A) you should get a new valuation every twelve months, or when materially necessary, to maintain safe harbor. A material event is an event that could reasonably be expected to affect a company's stock price
4. 409A valuation methodologies and founder goals
When it comes to 409As, you'll want the lowest strike price possible. Why? The lower strike price for employees to exercise options means a greater realization of value if the company succeeds. The lower the strike price of an option, the more the option holder will receive when they sell the underlying stock.
Some founders worry that a lower 409A will make their business look bad to current or future investors. This is not the case. Investors know that a 409A is strictly used to set common stock prices - they won't use your 409A to evaluate your business.
The Market Approach, Income Approach, and Asset Approach are the three most common methodologies valuation providers use during a 409A.
OPM Backsolve (Market Approach):
The OPM Backsolve is used when your company has recently raised an equity financing round. It can be safely assumed that new investors paid a fair market value for the equity, which is used to estimate the company's common FMV. However, adjustments must be made because most new investors are receiving preferred stock. Other Market-based Approaches use financial multiple information (revenue, net income, EBITDA, et cetera) from publicly traded comparable companies to estimate the company's equity value..
This straightforward approach is used for companies that have sufficient revenue and positive cash flow.
This is by far the least common and least supported valuation approach. This is for very early stage companies who have not raised money and don’t generate revenue. This approach calculates a company's net asset value to determine a proper valuation for a company.
5. Avoid 409A penalties
The whole point of the 409A is to protect your company from a potentially costly audit and to protect your employees from significant penalties. Early stage startups with very low option prices might be the least likely to get audited, but with the current cost of valuations so low, why risk it at all?