If you work for a startup, you may have heard the term “409A” thrown around as it relates to your stock options. The term stems from Internal Revenue Code Section 409A which regulates nonqualified deferred compensation paid by a service recipient to a service provider. Section 409A was enacted, in part, as a response to the Enron scandal where executives were accelerating payments under their deferred compensation plans in order to access money before the company went bankrupt. As a result, Section 409A requires companies to issue stock options and other forms of deferred compensation such as restricted stock units (RSUs) at an exercise price equal to or less than the fair market value (FMV) of stock.
While most public companies can issue this type of equity at a strike price equivalent to their publicly traded stock price, private companies and especially startup companies do not have that luxury. As such, private companies should hire a qualified appraiser to perform a 409A valuation to determine the value of their equity. When the valuation is conducted by a third party, independent, qualified appraiser, it establishes safe harbor, meaning the valuation is presumed to be reasonable by the IRS. Without this, a company can be subject to penalties by the Internal Revenue Service (IRS) if the equity is priced incorrectly.
When is a 409A valuation needed?
First and foremost, a company should obtain a 409A valuation before they issue any equity incentives including options, RSUs, and warrants issued for service. For companies that are issuing equity on a frequent basis, valuations should be completed once every 12 months unless there is a material event that could impact the stock price, a qualified financing such as raising a round of venture capital, or if the company is approaching an initial public offering (IPO), merger, or acquisition. A material event could include any of the following:
- A significant new or lost contract that represents a material change in revenue
- Any material, closed acquisition that involves the company as a buyer or seller
- Strategic partnership that results in a material change in revenue or margins
- Regulatory changes that result in a material change in revenue or margins
How are 409A valuations determined?
Qualified appraisals will use a combination of three different approaches to value the subject company:
- The asset approach: This approach is based on the value of the subject company’s assets net of liabilities and may be considered for a pre-revenue startup. A common methodology is the cost to recreate method which may be applied to specific technology that is in process of being built. The cost to recreate is the “cost to construct, at current prices, an exact duplicate of the subject. The duplicate would be created using the same materials, standards, design, layout, and quality of workmanship used to create the original subject.”¹
- The income approach: This approach determines the value of a business by converting anticipated economic benefits into a present single amount using procedures that consider the expected growth and timing of the benefits, the risk profile of the benefits stream, and the time value of money. The two common methods used under the income approach are:
- The single period capitalization method: a representative benefit level is divided or multiplied by an appropriate capitalization factor to convert the benefit to value.
- Discounted future benefits method: benefits are estimated for each of several future periods, and are converted to value by applying an appropriate discount rate and using present value procedures.
- The market approach: This approach determines value of a business through the comparison of the subject to similar businesses that have been sold. The three common methods used under the market approach are:
- The guideline public company method: market multiples are derived from market prices of stocks of companies that are engaged in the same or similar lines of business and that are actively traded on a free and open market.
- Guideline company transactions method: pricing multiples are derived from transactions of significant interests in companies engaged in the same or similar lines of business.
- Backsolve method: based on a recent transaction in a company's equity as a way to imply a total enterprise value and impute the value of other equity securities previously issued and outstanding. This is a preferred valuation method for private companies who have recently sold securities, especially when other forms of the market approach or an income approach are either unavailable or less reliable. The backsolve method considers the terms of all outstanding equity classes and debt and the expected timing to a liquidity event to value each class of stock while ensuring the allocation method values the recent preferred issue at its transaction price.²
409A valuations are complex and will determine the issuance price (i.e., the strike price) for equity incentives including options, RSUs, and warrants issued for service. It is imperative to perform these assessments every 12 months and to work with a seasoned professional who understands the nuances of these valuations to avoid lawsuits, tax liabilities, and penalties by the IRS. Citrin Cooperman’s dedicated professionals are highly skilled in performing these valuations and can help you focus on what counts — strengthening your business.
¹ Valuing a Business: The Analysis and Appraisal of Closely Held Companies,” Fifth edition, by Shannon P. Pratt with Alina V. Niculita, 2008, page 370
² ”10 years old, 10 years wise: The evolution of 409A,” by Robert Barnett, May 27, 2017.
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