409a Valuation Ultimate Guide - What it is, FAQs, and More
As a business owner, you may often have to deal with your company’s valuation for investment rounds, equity dilutions, etc.
One key valuation component is the 409A valuation, which is essential to a company's financial health and regulatory compliance but may seem complex.
Worry not! This detailed guide will help you gain all the knowledge you need.
You can also connect with expert valuators to discuss your unique needs. Exitwise helps you hire the best M&A professionals who understand your requirements and offer personalized solutions.
What is a 409A Valuation?
A 409A valuation is an unbiased, third-party assessment of the fair market value (FMV) of a private firm's common stock. The evaluation is guided and regulated by the Internal Revenue Service (IRS's) Internal Revenue Code, specifically, section 409A.
This valuation aims to establish the cost, often called the "strike price,” at which a person or organization can purchase equity in a non-publicly traded company.
Do I Need a 409A Valuation?
You will legally need a 409A valuation if you own:
A private company that issues equity or options
A startup that offers stock benefits to their employees
This valuation helps investors and stakeholders determine the correct value of preferred stock and may also increase or decrease the capital investment.
When is a 409A Valuation Required?
If your company is listed on the stock exchange or offers private stocks to employees, you will need a 409A valuation:
At least once every 12 months, or
In case of a 'material event' (new funding, undergoing M&A, etc.) that could affect the company's value
You must ensure your company adheres to these requirements and conducts valuations on time to avoid legal implications.
409A Valuation Requirements Explained
The requirements for a 409A valuation are established by the Internal Revenue Service (IRS) in the United States. Here are the essential ones:
1. Fulfill Contractual Obligations
If your company wants to enter an M&A transaction, a 409A valuation is essential before entering the deal. Both parties (acquirer and target company) must fulfill any 409A valuation obligations.
2. Regulatory Compliance
The company must comply with all relevant laws and regulations.
3. Frequency of Valuation
Under US tax law, companies must do a 409A valuation at least once every 12 months or in case of a 'material event' (merger, change of business methods, funding, etc.) that could affect the company's value.
4. Professional Appraisal
An independent, third-party qualified appraiser should do the valuation. It ensures that the valuation is unbiased and adheres to professional standards.
Your company may be penalized if you fail to comply with these requirements.
Understanding 409A Valuation Calculations
A 409A valuation involves a multi-step process that includes the analysis of financial statements, risks, legal liabilities, and current capitalization. Understanding the calculations involved in a 409A valuation is crucial, and here's a simplified explanation of the process:
Step 1: Estimating the Enterprise Value
The first step in a 409A valuation is to estimate your company's total value, known as its "enterprise value." This is typically done using financial data such as revenue, growth rate, and profitability and market data such as the valuation of comparable companies.
Three methodologies are used for a 409A valuation: the Income approach, the Market approach, and the Asset approach.
Income Approach: In this method, valuators estimate a business's ability to generate income by projecting its future cash flows.
Market Approach: Also known as the option pricing model (OPM) backsolve method, valuation providers use this method when your company raises any financing. The new investors pay the FMV for the equity but receive preferred stock. Accordingly, this method adjusts the FMV for the common stock.
Asset Approach: Here, valuators measure the value of an asset or business by analyzing similar recent sales or comparable investments or assets.
Step 2: Allocating Value
Once the enterprise value is determined, it is allocated across the various classes of equity (common stock, preferred stock, etc.) to arrive at the FMV for the common stock.
Step 3: Discounting the FMV
The concluding step is to apply a discount to the FMV because the stock is not publicly traded. This "illiquidity discount" reflects that private company stock is less liquid (more stringent to sell) than publicly traded stocks on the stock exchange.
It's important to note that an independent, qualified appraiser must perform a 409A valuation to ensure accuracy and compliance with IRS regulations.
Is There a Good 409A Valuation Calculator?
Absolutely. Here’s the Exitwise business valuation calculator, which offers accurate valuation based on comprehensive calculations.
However, calculators can only provide an estimate, so you should engage a professional third-party valuation service for an official 409A valuation.
5 Common 409A Valuation Comparisons Explained
For many business owners, 409A valuation may seem new and uncommon. Here's a comparison with other standard and relevant valuation methods to give you an idea.
1. 409A Valuation vs. Fair Market Value
A 409A valuation is a method used to determine the fair market value (FMV) of a company's common stock.
The FMV is the price that an asset would command in a sale between a willing buyer and a willing seller, where both are well-informed about the relevant details and neither is under any pressure to buy or sell.
2. 409A Valuation vs. Investor Valuation
A 409A valuation is the independent appraisal of a company's common stock value, sometimes called the 409A price. The IRS requires the determination of the fair market value (FMV) of common shares for tax purposes. Unlike venture capital (VC) valuations, 409A valuations focus on the FMV of a company's existing common shares, not the company's overall future potential.
On the other hand, investor or VC valuations are the market values that entrepreneurs and venture investors agree upon, and these valuations consider the company's future potential.
Note: a 409A valuation can be essential in VC valuation estimates.
3. 409A Valuation vs. Post-money Valuation
A 409A valuation is done by compliance experts and is estimated at the lower end of a valuation range.
On the other hand, the post-money valuation is the market value calculated after a company receives investment from venture capitalists (VCs) or other sources.
You can perform the post-money and 409A valuations simultaneously, but each will yield different values.
4. 409A Valuation vs. Strike Price
A 409A valuation establishes the fair market value of a company's shares and sets the strike price for your employee stock options.
The strike price, sometimes also known as the exercise price, is the predetermined price per share at which stock can be purchased in a stock option agreement.
5. 409A vs. Preferred Price
The preferred stock price is used to sell a company's stake to investors and is slightly higher than the strike price calculated from a 409A valuation. That’s because the preferred stock usually comes with additional rights that make it more valuable, such as liquidation preferences and the power to block financings or sales.
The 409A valuation, on the other hand, reflects the value of the common stock, which does not have these additional rights.
Frequently Asked Questions (FAQs)
Look at some commonly asked questions about 409A valuation.
How Much Does a 409A Valuation Cost?
The cost of a 409A valuation varies depending on the size and complexity of your business and can range between $1,000 to $10,000+. Some companies also offer valuations on a monthly subscription basis.
How Long is a 409A Valuation Good For?
A 409A valuation is valid for 12 months from the date of the issuance of the valuation report or until a material event occurs that could reasonably affect a company's stock price.
How Long Does a 409A Valuation Take?
Your 409A valuation can take a few days to a few months, depending on your company’s needs and situation. Generally, if all the required items are available, it takes about two weeks to get to a final draft of the 409A valuation.
Are 409A Valuations Public?
No, 409A valuations are not public, unlike valuations for publicly traded companies. Private companies use them internally to calculate the fair market value of their common stock issued to employees and other stakeholders.
Conclusion
Understanding 409A valuations is crucial if you’re planning to issue equity or options. While the process can be complex, a clear understanding of a 409A valuation can help you navigate this process more effectively.
Always consult with a professional to ensure accuracy and compliance since a 409A valuation can only be done by a third party.
Need help figuring out where to begin? Exitwise can help you find the right professionals for your 409A valuation and other M&A transactions. Connect with us today, and we will help you hire the best M&A team.
