The term 409A valuation has originated from Section 409A of the American tax code. The 409A section deals with non-qualified deferred compensation plans. By the guideline of Section 409A, private firms should offer their employees equity on a tax-free basis. Generally, a 409A valuation method is incorporated to assess the value of shares that a private organization offers to its employees. Now, first thing first. What is a 409A valuation and how does it impact a startup?
409A Valuation to Startups
A 409A valuation is often defined as the assessment of the Fair Market Value (FMV) of the common stock of a private firm. Typically, the assessment is undertaken by a third party to maintain transparency. Common stock is determined as the share of a private organization reserved for both founders and employees.
Now, in reality, startups pay for the assessment i.e. the 409A valuation however they use their own findings to decide the price at which they distribute the share of the common stocks. As we discussed before, by the guidelines of Section 409A, all private companies are liable to carry out the assessment by a third party. Deferring from this could even lead to serious legal actions.
Furthermore, a startup must complete the formalities related to 409A valuation since the value of a newly formed organization is not readily available. On the contrary, companies that are listed with the public stock exchange have a legal valuation pre-recorded. Therefore, to determine the value of the company or the common stock of the startup, a thorough 409A valuation is required.
Now to understand the importance of 409A valuation to startups, let us take a case study.
A Case Study of 409A Valuation to Startups
As the founder of a startup, you must be pondering about the expansion of business, stability, growth of the business, line of trade, etc. which will create a solid base for your company. Then, why are we emphasizing more on 409A valuation to startups? Is there any exemption of the law?
As a matter of fact, there are certain cases or scenarios already mentioned that exempt startups from a 409A valuation.
The scenarios are:
Scenario 1: If your startup is not big enough or incapable of offering the 409A valuation fee, then an internal assessment or internal appraisal will be sufficient.
Scenario 2: A firm may go for an internal evaluation if the following criteria are met.
- The organization must in business for ten or less than ten years
- There should not be any record of publicly traded security
- The private firm (startup) must not have a plan to merge with a bigger body or go public in any form in next 90 days
- There should not be any put or call option or other similar onuses on common stock
How Full Market Value (FMV) of a Startup is Calculated?
To understand the importance of 409A valuation to startups, you must have a fairly clear idea of the calculation of the Full Market Value or FMV. Usually, every startup employs an expert market analyzer who assesses the value of the common stock of the company by comparing it to the same of a publicly registered company. In simpler words, startups calculate their market value by comparing the common stock with the common stock of a company that is listed with the public stock exchange.
You may wonder, why do we need to draw a comparison?
The answer is self-explanatory. When a company is listed on the stock exchange, the financial implications of the common stocks of those organizations are declared publicly. Using this particular knowledge, an assessor calculates the amount of common stock of a startup and then eventually finds out the Full Market Value (FMV).
Safe Harbor Process
This is a process of internal appraisal where startups use the leverage of illiquid insider evaluation safe harbor method. While doing the analogous study, i.e. drawing comparison during internal appraisal, startups must remember the following points.
- In case of an internal evaluation, the assessor must draw comparisons with at least 5 organizations to determine the Full Market Value (FMV). No less than five registered companies should be fabricated during the appraisal
- The organizations you use in the initial days to determine the FMV must be used in the following appraisals as well. Putting it otherwise, you must use the same organizations as your reference market value
- The IRS allow adding fresh organizations to the appraisal process only when the new organization you opt to add is highly comparable
This entire process is known as a safe harbor. Appraising the FMV internally using the reference market values of bigger organizations is the safe harbor of a startup. However, a startup must refresh the 409A valuation every 12 months. If not done so, the safe harbor will be deemed invalid. Besides, a company will be required to refresh their 409A valuation if and when:
- The company opts for issuing a common stock option
- The company is deciding on a significant event i.e. new financing, new business model, change of line of business (LOB) etc.
- The startup is going to apply for an IPO or a merger
- The company is going for an acquisition (acquiring smaller business(es)
This is the basics of 409A valuation to startups. One must keep these basic aspects in mind while running or forming a startup company.
Conclusion
409A valuation to startups is as important as it is to bigger private firms. By doing a 409A valuation, you are eligible for multiple facilities including financing, merging, acquiring, and applying for an IPO. These are absolutely important to a startup for sustainable growth. As a startup owner, you may rely on the safe harbor process but that should not be the permanent solution, particularly if you are aiming for growth. The IRS audits startups at random and any discrepancy in the internal appraisal will lead to legal consequences. Therefore, a 409A valuation to startups is the ideal and permanent solution for viable and seamless growth.