Importance of 409a valuation for your startup

The word 409A valuation derives from Section 409A of the United States Internal Revenue Code. Section 409A addresses non-qualified deferred compensation plans. This Section dictates that private companies should provide equity to their employees on a tax-free basis. An employee stock option plan is often valued using a 409A valuation approach, which is commonly used in the private sector.

So, what is a 409a valuation in general?

The majority of founders aspire to take their businesses public. Until that dream is realized (or another one is attained), it might be difficult to comprehend the value of a startup along the journey. The value of publicly traded enterprises is determined by the market. However, private enterprises rely on independent evaluations and private valuation. This is where 409a valuations come into play. A 409a value is an essential term and concept that founders must understand.

A 409a valuation is the fair market value (FMV) of the common shares of a private firm. This FMV is decided by a third-party evaluation. Common stock is the shares reserved for the company’s founders and employees. A 409a value determines the price of an individual share.

The industry progress of 409a valuation

The global market for 409A valuation services comprises a significant number of small to medium-sized competitors. There are only a few major players with worldwide recognized knowledge and the financial resources to manage any obstacles, including lawsuit and settlement demands.

The increased need for organizations to examine their internal systems to guarantee they can handle complicated financial reporting obligations is driving the expansion of 409A valuation services.

As the global economy continues to recover from the financial crisis, there is a growing demand for individuals who can provide objective advice in these fields. The market is also anticipated to gain from the increasing consolidation of the accounting industry and the rising demand for specialists.

Why a 409A Valuation is important for private companies?

The Importance of 409a valuation is that it enables businesses to comply with all tax regulations and avoid IRS audits that might lead to legal issues. If problems emerge, they may even disrupt the company’s operations.

The majority of employees would prefer to work for a company that protects their rights. In the event of urgent tax problems, the employees would be the ones to suffer the most. Therefore, it is more advantageous for a corporation to do 409A reviews. Overall, this assessment safeguards your organization against expensive legal and tax expenses. In addition, it provides investors with a snapshot of the company’s financial health.

Penalties on the breach — 409A valuation penalties — Not only will the sanctions kill your business, but they will also ruin the lives of your employees. Examples of employee tax penalties for violation of Section 409A:

• All deferred vested amounts under the NQDC plan must be paid to the government before the end of the vesting year, or a 20% penalty will be assessed.
• If employees fail to pay compensation after the vesting date, they will be subject to a premium interest tax equal to 1 percent over the federal underpayment penalty. Additionally, employees may be susceptible to state-imposed fines.

To avoid penalties, when do you need a 409a valuation for your startup?

To underline the validity period of a 409a valuation — A 409a valuation is only valid for a maximum of twelve months following its date of issuance. The sole exception to this schedule is if a significant event occurs before the 12-month mark.

As 409A valuations are only valid for one year, therefore if no major events occur within a year of the prior assessment, you must proceed to submit 409A each year. You may require a 409A valuation:

Before you grant stock options to your first employee or advisor. Generally, you should obtain the first 409A value of your company before issuing the first common stock options (which are typically granted to your first hire or advisor).

After any significant incident, material events are typically fundraising rounds, although they can also be any substantial operational or financial development, such as economic shifts.

Should you revise your 409A due to the fluctuating market? Is the shifting market a market event for your business?

Numerous elements can affect your valuation, including financing terms, the macroeconomic situation, and the volatility of the public market.

Recent volatility in the public markets is likely to have a particularly damaging effect on venture financings and valuations as investors reevaluate their risk appetites. Analysis reveals that some companies have postponed their IPO aspirations or have experienced a drop in their own 409A valuations. This market shift could present an opportunity to grant options with a reduced strike price (though that may not happen for every company).

Questions to be addressed on market uncertainty

Did you raise funds at the end of 2021 or at the start of 2022?

In late 2021 and early 2022, market conditions were substantially more favorable than they are today. If you raised capital during this time period, you may be eligible for an equity adjustment that could result in a decrease in your startup valuation.

Have you made substantial adjustments to your estimates?

Most companies will be impacted by a prolonged downturn. Your finance staff may be preparing revised forecasts. It is often necessary to reevaluate your valuation to account for these changes when you revise your forecast.

Are you planning to raise financing in the near future?

If you’ve planned to obtain money this year, your cash reserves may be depleting at a time when funding is either expensive or (perhaps) unavailable.

Are you cutting your cash outflow in view of the funding market?

The risk connected with having little funds may need to be reevaluated if you have less cash on hand.

Plan an exit within the next twelve months?

As a result of market instability, the transition from private to public companies is taking much longer. Especially if you operate in a sector that has experienced a major downturn in the public stock market, such as technology, you will likely need to reevaluate your assumptions regarding the projected time to exit.

Get your 409A valuation

Overall, 409A valuations safeguard your business from audits and employees. It saves your employees considerable time and effort. Therefore, if you believe you are ready for a 409A valuation, you should retain a skilled third party with the necessary knowledge and experience to produce an accurate FMV. A well-planned 409A valuation will save you much time and effort in the long run.

What is the cost of a 409A valuation calculation?

In the United States, the cost of a 409A valuation ranges from $1,000 to $10,000, depending on the size of the company and the complexity of the assessment; however, there are specialty vendors that may offer a reduced price for a restricted 409A valuation, get in touch with Eqvista for more details.