Why Does a 409a Valuation Matter?

Written by Amanda Bower    |    Published: August 9, 2022

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Valuation is one of the key performance indicators for any startup. However, not all evaluations are the same. A market valuation is different from a 409 valuation, which are both different from a comparable analysis. When your startup is ready to start attracting investors, which valuation gives you the competitive edge.

A 409a valuation helps your business go beyond cash flow and other metrics, helping you showcase the strength of your two strongest assets: Your product and your team. Before going to your next investor presentation, here’s what you need to know about creating a 409 valuation and how it can help you win more partnerships.

What Do We Mean by a 409a Valuation?

The term “409 valuation” refers to Internal Revenue Code Section 409a, which governs how taxes are applied to stock options. Prior to 2007, stock options were not considered taxable until an employee exercised them.

Section 409a was introduced in 2005 as part of a larger jobs creation package, changing how companies deal with “nonqualified deferred compensation.” In summary:

  • Under Section 409a, companies have restrictions against the acceleration of benefits, nonqualified deferred compensation distribution timing, and the timing of deferral elections. In most cases, compensation can only be dispersed after a fixed amount of time has passed.
  • Taxes are applied to incentive stock options or nonqualified stock options – otherwise known as equity-based compensation – that are granted under the fair market value on the date of issuance.

To determine what the fair market value of a startup is, companies will create a 409 valuation. This requires an independent audit of the company to determine how much a share is worth at a given point in time.

What Does This Do for a Business?

If a small business is in a growth phase and plans on offering employees stock options as part of their benefits package, they will need to go through the process of a 409 valuation. Similar to how an appraisal is required before homeowners can close on a mortgage, the 409a valuation helps owners determine the reasonable present value of their company.

Creating a 409a valuation isn’t just for the benefit of attracting and retaining employees. When going through a startup funding round, businesses can use this measurement to justify their funding requests, showcase their positive growth over a period of time, and set an argument for why they would be a strong partner over time.

There are some other concerns key leaders also need to understand about a 409a valuation. Both the Internal Revenue Service (IRS) and Securities and Exchange Commission (SEC) can challenge a 409a review if they believe a reported valuation is too low or too high. Startup leaders should be prepared to work with their accounting team to ensure an audit is factual and defendable.

Can I Do It Myself?

Although your internal finance team could do a 409 valuation on their own, it isn’t always a good idea. An internal 409a valuation audit may not get accepted by the IRS, losing both time and money which could be better spent working on moving your business forward.

One of the key benefits of outsourced accounting is the ability to hand off creating a 409a valuation to your expert partners. With your historical data, cash flow patterns, and other key performance indicators at hand, an outsourced accounting partner can work with your auditor of choice to not only create a valuation that reflects your company’s position today but is also defensible to the IRS, helping you find success starting from the first time.

How Often Do They Need To Be Done?

There are three occasions when you will need to get a 409a valuation. The first is when you start hiring employees with stock option plans.

To attract top talent, startups will often use stock options as part of a robust employee benefits package. Offering stocks gives the worker a personal stake in both their and the company’s success, rewarding them with long-term value as the company grows. But before a small business can offer those stocks, they need to assign a fair market value. A 409a valuation gives companies a basis to determine how much a share is worth, allowing employees to understand their value today and their potential growth over time.

The other time your company would need to do a 409a valuation is when there is a material event, such as a qualified financing round. After an individual, accelerator, or venture capital firm invests in startups for equity, their fair market value changes based on the amount of cash raised. As a result, your finance team will need to update the 409a valuation to ensure your business remains compliant with the IRS.

What Do I Need To Do for the 409a Valuation?

Before you can start the 409a valuation process, your team will need to collect information about your startup financial model. Some of the information an auditing firm will require includes:

  • The most recent pitch deck for potential board members and investors.
  • Historical company data over the past three years, including profit and loss data, cash balances, and a projection of potential debt obligations.
  • An idea of how many stock options will be offered to employees for the next year.
  • A list of publicly-traded companies similar to your business in size, structure, and cash flow.

In many cases, this data can be captured in returns from your outsourced business tax services. For others, working with your financial team or outsourced partners can help you fill in the blanks to create a complete picture of your company’s fair market value.

What’s a Safe Harbor Valuation?

In terms of a 409 valuation, a “safe harbor valuation” is accepted by the IRS as the valid fair market value of your company. Making sure you meet the requirements for safe harbor valuation could make future valuations easier and set your company up for success.

With a safe harbor valuation, the IRS agrees that your estimate is valid and correct unless they can prove that it is “grossly unreasonable.” If the IRS decides to challenge your estimate, the burden of proof is on the government.

Once established, a safe harbor valuation is valid for 12 months from the day it was issued unless your company issues more stock options to employees or experiences a material event. If your company does not experience either situation in a year, your valuation may still be considered valid – but it won’t necessarily be considered the “safe harbor valuation.”

What About if We Offer Stock?

If your company decides to offer common stock to partners through an equity investment or employees as part of a compensation package, you will need a 409a valuation to get started. This establishes fair market value, helping partners understand how much their shares are worth.

Alongside determining a fair market value, the 409 valuation will determine your common stock’s “strike price,” or how much an individual or company will pay to exercise a stock option. Once the price is calculated, it is set in stone for that round of stock. That is, no matter when one goes to exercise their options, they will pay that price for the stock regardless of its value today.

What Is Not Considered a 409a Valuation?

In order to meet the requirements of a 409 valuation, an estimate must reflect the fair and accepted value under the terms of the IRS. As a result, your startup’s 409a value may be different from any other models you may be using.

When trying to attract new investors or partners, your company may use other models – including financial forecasting and cash flow analysis – to showcase your growth over time. However, these do not meet the requirements of a 409 valuation because they do not reflect the fair market value of a share, nor do they establish the strike price of exercising an option.

In short: A 409 valuation considers what your company is worth to shareholders at the time of the analysis. Other valuation measurements are performance indicators, which help showcase past performance and suggest the future of your company.

409a Valuations Done Right

If you’re never experienced it, going through a 409a valuation can be stressful and taxing. When you partner with an outsourced accounting team that focuses on getting this right for partners, you can rest assured it will be correct and accurate the first time, taking a weight off your shoulders.

At hiline, we’re committed to helping organizations understand their 409a valuation. It all starts with proper documentation, record keeping, and managing your balance sheet correctly. Schedule a call today to learn how we can help you scale your business upward with the right accounting and planning tools.

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