409a Valuation Methods: How to avoid issues with the IRS
The purpose of a 409A valuation is to determine the value of the shares that your privately held company can offer to your employees in the form of stock options on a tax-free basis. It’s imperative to be diligent in getting an accurate, thorough 409A valuation for the benefit of your company and to avoid having issues with the IRS.
You’ll need to allow for sufficient time to gather the essential data and materials together and complete the valuation. If you choose to hire a firm to do your valuation, it’s crucial to contract with a qualified firm with a good reputation to avoid penalties.
In this article, you’ll learn about what data you need for a 409a valuation, how to choose a valuation firm, and the 409a valuation methods you can use to avoid having issues with the IRS.
What Data Do You Need for a 409A Valuation?
When gathering information for your 409A valuation, you’ll need information about your company, your industry, the timing of possible liquidity events, financial statements, and any relevant events since your last 409A valuation.
Provide information on your company that includes the names of your CEO, legal counsel, and external audit firm, if you’re using one. Also, include the most recent copy of your articles of incorporation or corporate charter.
Part of a 409A valuation depends on a comparison between your company and comparable companies. For that reason, your valuation should include a list of five or more companies that you consider to be relevant and comparable to yours. Don’t worry if your company doesn’t fit squarely into a particular industry. The IRS is accustomed to reviewing companies that are disruptive to the marketplace. Bear in mind that the comps you choose will become part of all subsequent 409A valuations, so you want to be sure that the ones you choose make sense. You should only add new comps when new companies that are highly comparable go public.
If you just completed a fundraise, you should also include your board presentation, a recent pitch deck, and business plan or executive summary.
Another thing that you’ll need to do is estimate how many options you anticipate issuing over the next 12 months. A good rule of thumb is to take the number from your hiring plan and multiply it by the median number of options per employee. Be sure to adjust for the allotments for expected executive hires.
Be clear about your expectations around the timing of potential IPO or M&A events, as well as significant events that have occurred since the last 409A valuation. If this is your first 409A valuation, include a complete history of significant events.
Considering your financial statements, you should include your forecasted revenue and forecasted EBITDA for the next 12 months, starting from the valuation date to the next two calendar years. Also, include your three-year profit and loss statement, debt projections, and cash balance. New companies only need to make this best effort as they don’t have enough history to be highly accurate.
As complicated as all that sounds, Diligent Equity, software that manages your cap table, helps to make it easy. With Diligent Equity, you can streamline your workflows around new grants and your board’s approval. The program allows you to manage and monitor your stocks, options, warrants, and convertible notes. You can also import shareholder allocations and set alerts for ongoing maintenance. Best of all, your data will be stored on secure servers.
How to Choose a Valuation Firm
Calculating the enterprise value is the first step in a 409A valuation. The second step is to allocate the enterprise value across various equity classes, which will give you the fair market value for the common stock. The third and final step is to apply a discount to the fair market value to credit for the company not being publicly traded.
While anyone can do a valuation, it’s best to have a qualified, independent valuation provider conduct your 409A valuation. A valuation firm will strive to ensure that your valuation is reasonable, which the IRS considers as a “safe harbor” for your company. The valuation company you select should have experience valuing companies that are comparable to yours, including the sector, stage, and industry. It also helps if your valuation provider has strong relationships at large audit firms. Be aware that even if you take all the right steps and precautions, the IRS can still challenge your valuation and you’ll need to defend it.
409A Valuation Methods
There are three commonly accepted 409A valuation methods—the market approach, the income approach, and the asset approach. All but the market approach uses financial information like revenue, net income, and EBITDA from comparable companies.
As companies grow and change, valuation providers may use these three methods in combination with each other and change the approach as companies mature.
The Market Approach
The market approach is used for early-stage or unprofitable companies where it’s difficult to predict the long-term financial performance. The market approach is also called the OPM backsolve method. This method accounts for the fact that new investors pay a fair market value for their shares while investors receive preferred stock. The market approach adjusts for the fair market value for common stock.
The Income Approach
Valuation providers like to use the income approach for companies that have adequate revenue and a positive cash flow. This approach defines the company’s fair market values as the amount of total assets and subtracts the corresponding liabilities.
The Asset Approach
Valuation providers often use the asset approach for companies that don’t generate revenue and haven’t yet raised money. This approach uses the net asset value to arrive at the proper valuation.
Valuation providers must also factor in certain economic rights like liquidation preferences, participation rights, and conversion ratios.
There is much involved in getting a proper valuation that you can defend with confidence. That’s why it’s essential not to take the 409A valuation process lightly. The IRS typically doesn’t randomly audit startups. Despite that, they’ll be quick to impose penalties on companies that can’t justify their valuations. The time and investment that you make in software like Diligent Equity and in contracting with a reputable valuation provider are well worth the time, effort, and expense.
