The valuation of your business is likely to be a major concern for you as an entrepreneur, as is the case for most people. As a result, public enterprises are not as free as privately owned ones. In the case of publicly-traded enterprises, the value is often determined by the market.
On the other hand, private businesses rely on third-party appraisers to determine their company's worth. If your organization is preparing to issue stock options, you'll want to become familiar with the 409A valuation method. Recently, the 409A valuation has changed a lot. As you can see, there is a lot to consider when it comes to distributing your company's equity in an ethical manner. For your company's benefit, let us learn more about the 409A value.
What is a 409A Valuation?
A 409A valuation is a computation of the fair market value of a private or startup company’s common stock by an independent appraiser, that is, a third party. This valuation’s name originates from section 409A of the US Internal Revenue Code. This valuation helps determine the cost of purchasing a single share of the company.
Anyone will easily be able to see the specific prices of publicly traded stock at any time on a particular day. However, for private company stock, an independent valuation is important to find out the worth of your company’s stock.
It is a procedure that consists of three different steps. The first step determines the worth of a company. It is followed by the second step, which involves the allotment of the enterprise value to the various separate equity classes so that the company can arrive at the fair market value (FMV) for the common stock.
The final step is to apply a discount to the fair market value to take into consideration that it is not a publicly-traded stock. All private companies are suggested to follow this framework while evaluating their private stocks.
Why Should Private Companies Hire a 409A Valuation Firm?
Your company needs to prove that the fair market value of the common stock that has been calculated is reasonable. That ensures that the stock option grants are structured properly as tax-free events for various employees. The valuation reports are usually presented to the IRS. The status that the valuation acquires if it is validated by the IRS is popularly known as “safe harbor.”
The safest and most convenient way to ensure 409A safe harbor is to hire an experienced and skilled 409A valuation provider to perform a thorough analysis. So, hiring a successful and renowned firm will oblige your company to comply.
However, to be on the safer side, it is always wiser for the founder/CEO to ensure that the evaluation work has been carried out precisely. Even after it has been conducted by an expert independent provider/ firm, the analogy can often be challenged.
How to Select the Most Appropriate 409A Valuation Firm for My Company?
Hiring a long-term valuation firm is a massive leap of faith. Before your company makes this crucial decision, they must find out whether the firm that they want to hire shares the same company values as they do or not.
A desirable firm will have the correct credentials and extensive knowledge and experience. A firm that has previously worked with companies similar to yours will be able to serve you with better outcomes than a firm that has no experience with analogous clients.
It will also be smarter for companies to choose a valuation firm that has strong connections with major audit firms and local firms in their specific area. This is a clear sign of their performance over the years. It indicates that their work is defensible and respected by experts. Hiring a valuation provider with relevant experience and competency can help private companies in ways that they can't even possibly imagine.
How Often Should I Do a 409A Valuation?
Companies are advised to conduct a 409A valuation once every twelve months. However, if there is an occurrence of a material event that might affect the company’s value, then the company should immediately perform a valuation regardless of how long ago the last valuation was done. Such events can include instances of secondary sales of common stock, new equity financings, and good/bad changes to the company's overall financial outlook.
However, there is no specific rulebook that claims that valuation can be conducted only under these circumstances or annually. If the provider/ company thinks that they want to perform monthly or quarterly valuations, they can do so.
Factors That Influence 409A Valuation
We have gathered the information so far that the 409A valuation is an independent appraisal. So, to determine this, valuation firms or companies generally turn to one of the three famous approaches to appraise fair market value:
- Market approach: In this approach, firms analyze comparable public and private transactions and companies.
- Income approach: A company’s free cash flow is analyzed to determine estimates for the following five years.
- Asset approach: A company’s intangible and tangible assets are analyzed.
How to Calculate 409A Valuation?
Here are three steps for a 409A valuation calculation:
- Calculate enterprise value: The first step is undeniably the principal step in the entire process. This step basically involves estimating the company’s enterprise value. It is not a very complex step if the valuation is performed right after a fundraiser. However, if you conduct this step after a year or so, then it becomes more tedious.
- Determine the value of the common stock: After estimating the enterprise value, the second step follows. In this step, the various values are divided into different share classes to determine the current value of the common shares. All of the economic rights of each share class are taken into account in this step.
- Apply a discount for lack of marketability: The final step is to take the calculated fair market value for the common shares and apply a discount to adjust accordingly.
Which Documents will be Required for a 409A Valuation?
There are certain documents and information that you will require for a 409A valuation. These include the following:
- Balance sheet
- Cap table
- Income statement
- Article of incorporation
- Your industry documents
- Cash flow statement
- Previous 409A valuation
Importance of 409A Valuation in Private Companies
A 409A allows companies to follow all the tax laws and avoid any of the IRS audit sessions that can cause legal troubles. If problems arise, then they can even interfere with the company’s functions.
Most employees would want to work in a company that safeguards their rights. In case of immediate tax issues, the employees would have to suffer the most. So, it is more beneficial for a company to perform 409A evaluations. So, altogether, this valuation protects your company from enormous bills for lawsuits or tax liabilities. Moreover, it gives investors a quick glimpse at the company’s financial standing.
409A Valuation Penalties
The sanctions will not only destroy your company, but they will also devastate the lives of your workers. The following are examples of employee tax penalties for 409A noncompliance:
- All deferred vested sums under the NQDC plan must be paid to the government on or before the final day of the vesting year, or a 20 percent penalty will be imposed on the amount.
- In the event that employees fail to pay compensation from the vesting day onward, they will be subject to a premium interest tax equal to 1 percent over the federal underpayment penalty.
- Employees may also be subject to state-imposed fines.
Get Your 409A Valuation
Overall, the 409A valuations protect your company from audits and your employees. It saves your employees a lot of time and responsibility. So, if you think that you are ready for a 409A valuation, then you should hire a qualified third party with adequate knowledge and experience to evaluate to determine an accurate FMV. Conducting a well-planned 409A valuation will save you a lot of time and trouble in the long run.