Role of Financial Projections in 409A Valuations
While equity compensation has always been a powerful tool for attracting and retaining talent, the decline in 409A valuations since 2021, as shown in our 409A valuation index, has created an added advantage: enhanced tax benefits. To fully capitalize on this blessing in disguise you must prepare an accurate and defendable 409A valuation.
So, in this article, we will help you understand how to make accurate financial projections and their role in 409A valuations. Read on to know more!
How do financial projections impact 409A valuations?
An American company that issues equity compensation to its employees and other service providers must establish its fair market value (FMV) through a 409A valuation. The Internal Revenue Service (IRS) establishes the income from equity compensation as the difference between the exercise price and the fair market value (FMV).
Generally, valuation analysts will rely on one or a combination of three valuation approaches to establish the FMV. In one of these three approaches, the income-based approach, we rely on financial projections and discounting techniques to value the company.
You must study your company’s financial history, industry trends, and economic conditions to make financial projections. However, given how quickly business dynamics can change with new technology, changing customer preferences, and economic conditions, you cannot make reliable financial projections beyond a certain point.
Hence, we also consider the terminal value of the business, i.e. the value of the business at the end of the financial projections. This value is discounted and then added to the discounted financial projections to find the company valuation.
Why do we look at financial projections?
In any stock market transaction, the price is set based on an estimation of the value the buyer can expect from owning the stock. If you buy a stock hoping to resell it eventually, your only concern would be how high can you potentially sell it for and the risks involved.
Typically, we incorporate these risks into the stock price by analyzing how they could affect the financial performance of the company. This is a form of financial projections.
The investor who will end up holding the stock for the long term will be affected by the company’s cash flows. If the company does not have healthy cash flows, the expected dividend income will fall. This would reduce the company’s valuation in the eyes of the long-term investor.
Hence, such investors must also make sound financial projections to understand the true value of their investments.
While equity compensation is not the same as stock market investments, the idea is similar. The employee can either sell their stake or reap the benefits of dividends. Since the IRS needs to establish the current gain, it must look at the exercise price and the FMV which could be calculated through financial projections.
Factors to consider in making financial projections
Let us look at some of the factors that help in making financial projections for 409A valuations.
Financial history
Your company’s financial history will form the baseline for its financial projections. You must study trends in cash flows, expense patterns, profit margins, and how your balance sheet is changing. Studying these patterns and trends will help you estimate your company’s financial projections if the ongoing conditions were to continue.
However, we cannot assume that all industry and economic conditions will remain constant. So, we must make adjustments to suit the market condition forecasts.
Economic outlook
Economic conditions like recessions, booms, stagflation, and stable low growth affect business prospects universally. Hence, you must understand the economic outlook for the period for which you are preparing financial projections. In preparing financial projections, the economic conditions you must focus on are gross domestic product (GDP) growth rate, inflation, and interest rates.
A high GDP growth rate is beneficial since it represents increasing consumption and higher demand for goods and services. On the other hand, a low GDP growth rate is a result of falling consumption and low demand for goods and services.
Some inflation is necessary since it is a signal that demand for goods and services exceeds the supply and there is room for expansion. However, too much inflation can wreck a business’ unit economics.
Low interest rates encourage businesses to borrow to invest in new technology and expansion projects, while high interest rates can deter expansion plans by increasing the cost of financing.
Industry conditions
We cannot think of a company as separate from its industry. The regulatory factors, demand patterns, seasonality, supply chain dynamics, and changes in a competitive landscape that define an industry affect all companies within it. These factors can influence cost structures, marketing expenses, research and development (R&D) requirements, customer service expectations, and expected revenues.
Hence, by understanding how industry conditions are expected to change, you can make meaningful adjustments to financial projections.
Eqvista- Compliance made simple!
One of the three approaches to 409A valuation is the income-based approach which relies on financial projections and terminal values. When we prepare financial projections, we cannot simply assume that a company’s financial history will repeat itself. Instead, we must make preliminary financial projections based on trends in cash flows, balance sheet changes, expense patterns, and revenue growth.
Then, we must make adjustments to these preliminary financial projections based on economic and industry outlook.
Finally, we just need to discount the financial projections and the terminal value to arrive at the 409A valuation as per the income approach.
If you find financial projections challenging but must prepare some for the sake of 409A valuations, allow Eqvista to be of assistance. We have helped over 15,000 companies maintain tax compliance through our accurate and detailed 409A valuation reports. Contact us to know more!
