You started your tech company a few years ago with a vision to disrupt an industry. You’ve been heads down building the product, hiring a stellar team, and raising money from savvy venture capitalists who share your vision.
The business is growing fast, and it’s time to offer stock options to attract and retain top talent. But issuing options comes with IRS rules you need to follow, including obtaining an independent 409A valuation to establish the fair market value of your common stock, the 409A price.
This 409A valuation is different from your VC valuations and funding rounds. It’s a necessary compliance step, but also a chance to gain valuable insight into how an objective outsider views your company’s worth.
Read on to understand the difference between 409A valuations and VC valuations, and how to navigate the 409A process to your benefit.
A 409A valuation is an independent appraisal of a company’s stock value, which is sometimes referred to as the 409A price.
It’s required by the IRS to determine the fair market value (FMV) of common shares for tax purposes. This ensures employees pay appropriate taxes on stock options and stock-based compensation.
Unlike venture capital or investor valuations, 409A valuations focus on FMV of a company’s common shares today, and a not company’s overall future potential. They consider the company’s financials, growth, market position, and other metrics to determine what a willing buyer would reasonably pay for common stock at a specific point in time: today. VC valuations also consider future potential.
To obtain a 409A valuation, companies hire an independent appraiser. The appraiser analyzes the company’s financials, growth, industry, location, and other factors to determine FMV. They may use methods like discounted cash flow analysis, comparable company analysis, or recent funding rounds. The IRS requires valuations to be reasonable and thoroughly documented.
Companies typically get an initial 409A valuation when issuing stock options, then annual or biennial valuations to reassess FMV. Employees must pay taxes on the difference between the strike price of options and the current FMV. 409A valuations aim to provide an objective FMV so employees don’t underpay taxes.
While a lower 409A valuation may save employees money, the IRS could scrutinize unusually low valuations. A valuation much lower than a recent funding round could trigger an audit and penalties. Companies should work with an independent appraiser to determine an objective, well-supported FMV so that they don’t issue stock options at too low of a 409A price.
In summary, 409A valuations provide an objective measure of FMV for tax purposes. They differ from VC valuations which incorporate future potential. Companies should obtain initial and regular 409A valuations to properly assess 409A price and avoid issues with the IRS.
As an employee with equity in a private startup, you may go through a 409A valuation of your company stock options or common shares. This is very different from a venture capital valuation, though many people confuse the two.
While a 409A valuation aims to determine fair market value today of the company’s common stock, a venture capital valuation is focused on an investment price that factors in higher growth expectations.
VC valuations tend to be more aggressive and forward-looking. A 409A valuation provides a more conservative estimate of just the one class of shares (common shares) based on the company’s current financials and market conditions.
Some of the factors that may lead to differences in the two valuations include:
In summary, 409A valuations and VC valuations serve very different purposes and rely on different assumptions. While a high VC valuation is a reason to celebrate, a 409A valuation is meant to reflect the fair market value of your company’s stock for tax and compliance purposes. Both play an important role in the startup ecosystem.
A 409A valuation is an independent analysis of your company’s fair market value. It aims to determine an objective, supportable value of the common stock for tax and compliance purposes.
In contrast, a VC valuation is established through negotiations between your company and potential investors to determine the price of preferred stock that typically has more rights and privileges than common shares.
While it is theoretically possible for a low 409A price could influence venture capitalists during negotiations, such a situation is quite unheard of as VCs understand the purposes of a 409A price and the factors used to estimate it.
VCs conduct their own due diligence to assess your company’s potential and growth opportunities to establish an investment value range. They will consider factors like:
In addition to the factors above, there are some quantitative reasons for differences in conclusions between the two approaches. Some of the main differences include:
Rather than relying on your 409A report, VCs will evaluate your company’s unique attributes and risks to determine a financing offer that balances their potential return on investment with your funding needs.
It matters to VCs that you have hired third party valuation firms to estimate your 409A price because VCs care about complying with laws.
As a private company, you’ll need to obtain an independent 409A valuation to determine the fair market value of your common stock for the purpose of setting exercise prices for stock options and restricted stock units (RSUs).
The 409A valuation provides an objective assessment of your company’s worth based on its assets, financials, growth projections and other metrics. It differs from a venture capital (VC) valuation, which focuses primarily on a company’s potential for high future returns.
You’ll require a 409A valuation in several situations:
A 409A valuation provides an objective, defensible assessment of your company’s fair market value at a point in time based on its assets, financials, competitive position and growth prospects.
Because the IRS considers it a safe harbor, a properly conducted, independent 409A valuation can minimize the risk of adverse tax consequences from option grants and other share issuances. While a VC valuation focuses on future potential, a 409A valuation analyzes the company as it exists today.
Related Read: Check out this Real 409A Valuation Report Sample
A company’s 409A valuation is determined by several key factors that directly impact the final valuation amount. These factors may differ from those considered in a venture capital valuation.
A company’s revenue, revenue growth, and growth projections are some of the most significant factors in a 409A valuation. The higher the revenue and growth, the higher the 409A valuation. Revenue that is recurring or reoccurring is viewed more favorably than one-time revenue. If revenue growth is accelerating, it signals a healthy, thriving company.
A company’s profitability and projections also impact its 409A valuation. Profitable companies are less risky, so they typically receive a higher valuation. Profit margins, net income, and EBITDA are metrics that valuators consider. If profits are increasing steadily over time, it demonstrates the company has a viable business model and strategy.
The overall economic environment and conditions in the company’s industry influence its 409A valuation. When the economy is strong and the industry outlook is positive, valuations tend to be higher. During downturns or recessions, valuations are often lower to account for increased risk and uncertainty. Comparison to industry benchmarks and public company multiples provides context on market conditions.
A company’s management team is evaluated based on experience, expertise, and track record. An experienced team with a proven ability to execute the company’s strategy and vision will positively impact the 409A valuation. Lack of experience or a poor track record will negatively impact the valuation due to perceived risk.
A company’s capital structure refers to its mix of debt and equity. Less debt means less financial risk for equity holders and a higher 409A valuation. Complex capital structures with multiple classes of preferred stock can be viewed as more risky, resulting in a lower valuation.
In summary, revenue and growth, profitability, market conditions, management team, and capital structure are the primary factors that drive a company’s 409A valuation amount. Strength in these areas signals a healthy, promising company and results in a higher valuation. Weakness signals increased risk and leads to a lower valuation.
So you see, 409A valuations and VC valuations serve very different purposes. The former is a legally required process to establish a fair market value for your shares, while the latter is an investment tool used by venture capitalists to determine how much equity they want in exchange for funding.
As an employee or founder, understanding the distinction between these valuation types will help you make better decisions about your equity and compensation. Though the numbers may differ, keep in mind that one does not invalidate the other.
Your company can be thriving and raising substantial VC funding even if your latest 409A price is relatively low. The next time your CFO circulates the latest 409A report, don’t get dismayed. Instead, focus on continuing to build value through passion and perseverance. The rest will follow.
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