409A Valuation as a Strategic Advantage: Creative Approaches for Startups

A 409a valuation determines the fair market worth of the common shares of a private firm. If you’re a founder, you need this value to issue the stock options at an exercise price that’s at least equal to or greater than FMV.

This is necessary to prevent negative tax effects for option holders, as stated in Internal Revenue Service (IRS) Section 409A. Employees may have to pay substantial penalties and taxes if their stock options have an exercise price lower than the fair market value.

As a startup owner, you will give stock options to the employees and early founders as part of equity compensation. To do that, you first need to know the share’s value. 409a valuation helps determine the strike price at which you can provide stocks to your employees.

Understanding 409A Valuation

Deferred compensation includes any payment to a board member, employee, or consultant that they are contractually entitled to receive in a later taxable year. Severance pay, stock options, and other equity awards may all be subject to 409A. Even for accidental violations, severe negative tax implications apply if deferred compensation plans are not exempt or comply with Section 409A.

For stock options to be free of Section 409A, the exercise price must be higher than or equal to the FMV of the underlying shares as of the grant date. This is why most private companies that offer compensatory stock options regularly have their stock valued by an independent valuation appraiser; this process is called a “Section 409A valuation,” and they ensure that the stock option grants comply with this law.

Various factors influence the 409a valuation. Some of them are:

• Stage of Development — Potential investors can understand the company’s worth through its transparent financial records. The terms of prior investments and rounds and the startup’s or private company’s historical pattern can impact its 409A valuation.
• Growth Prospects — The possibility for future growth and expansion can be a major influencing factor in 409a valuation. If you showcase a strong reputation and high-margin profit, your startup will have a high value. Investors will be interested in companies that can enter new markets and attract more customers.
• Brand Reputation — Quality is everything. If your company has a good reputation for quality, you can expect a higher valuation. A high-quality product or service with a strong brand will attract more investors.

What are the Creative Approaches in 409a Valuation?

The companies may choose the creative approaches to arrive at a more accurate 409a valuation. The following are a few of them to consider:

Leveraging future potential:

For startups in their very early stage, where they do not have any revenue, 409a valuation providers may leverage the amount of proprietary information to evaluate the viability of these startups for possible future funding rounds. This is also called the “Benchmarking approach.”

The methodology uses accumulated start-up data to estimate the likelihood and conditions of a successful first startup round. The approach determines a projected valuation for the initial substantial investment round, typically as a multiple of the original capital contributed. The final valuation figure reflects the discounted predicted valuation based on the startup’s chances of successfully securing that round.

Alternative valuation methods:

Below are a few of the alternative valuation methods in 409a valuation.

Option Pricing Model (OPM):

The exercise price an option holder can pay to purchase the underlying shares is determined for each of the company’s stock classes as they are call options. The liquidation preference establishes the exercise price for preferred shares. The company bases the exercise price of common stock on the amount that remains after meeting all liquidation preferences.

Assuming no management segmentation, common stockholders will receive $0 if a company’s purchase price is lower than or equal to its liquidation preferences.

Probability-Weighted Expected Return Method (PWERM):

Various share classes are assigned probabilities based on the firm’s projected values. Their rights govern their involvement in multiple outcomes, such as an initial public offering (IPO), mergers and acquisitions (M&A), dissolution, or continuous operations.

The common stock values in PWERMs are often higher than in OPMs because liquidation privileges are gone in the IPO scenario when all the preferred stock converts to common stock.

Incorporating intangible assets:

It is more difficult to determine the worth of intangible assets than tangible ones since they lack physical appearance. As an intangible asset, the valuers can use the company’s brand to know its worth.

Assessing the company’s advantages and potential drawbacks in the market is crucial for this task. Then, using techniques such as the relief-from-royalty method, work out the hypothetical royalty you could save from the brand.

How to use 409a valuation for Strategic Advantage?

How a 409a valuation can help you make a strategic move for your business? The following points explain that.

Strategic Planning: Getting a 409A valuation helps a business understand its present valuation well. Strategic planning requires this knowledge, particularly when deciding on stock option grants, mergers & acquisitions, fundraising, or growth plans. It gives the management team knowledge about the financial situation and room for business expansion, which helps them make well-informed business decisions.

Attracting investors and talent: The main reason for conducting the 409a valuation is to know the strike price of the stock options. So, having an accurate 409a valuation is important to prove that your company has the potential to grow and succeed.

Also, in competitive industries, a strong 409a valuation and a fair value of stocks can be a powerful incentive.

Competitive positioning: Analyzing how rivals value the company can help the business owner understand how to position it in the market. It facilitates determining the company’s market position and pinpointing areas where it has to strengthen or capitalize on its advantages. A good valuation can also help the business project credibility and brand image, establishing it as a major force in its sector.

How Can Startups Optimize Their Positioning with Eqvista’s 409A Valuation Solutions?

If you plan to provide stock options to raise capital, a third-party 409a valuation is mandatory per the IRS. At Eqvista, we offer a 409a valuation specific to your company’s requirements to improve your market position.

Through our accurate valuation, startups can better understand their company’s worth and adjust their strategies accordingly. We address each startup’s unique needs and meet them effectively. Moreover, Eqvista’s 409a valuation will help you comply with the IRS regulation. Contact us now to learn how Eqvista can help you with an accurate 409a valuation.