What is a 409A Valuation?
Public companies are valued by the price their stock trades at in the market, but private companies need a valuation to determine the fair market value (FMV) of their equity. A 409A valuation also establishes the “strike price” (the price at which equity can be bought) that must be at or above FMV.
Why do startups need a 409A valuation?
Since 2004, a 409A valuation is required by law (IRS Section 409A was passed as part of the American Jobs Creation Act) if a private company issues equity or options. Non-compliance can have serious consequences. Undervaluing stock options can result in IRS penalties and lost compensation.
What are the most common 409A methodologies?
There is no universal formula to determine an appropriate value for an illiquid, non-controlling interest in a closely held company. Determination of value is a matter of judgment, which takes into consideration economic and market conditions, as well as investment opportunities that would be considered as alternatives to the interest being valued. The methods commonly used to value a closely held business include the following:
Income Approach
This approach focuses on the income-producing capability of a business. The income approach estimates value based on the expectation of future cash flows that a company will generate – such as cash earnings, cost savings, tax deductions, and the proceeds from disposition. These cash flows are discounted to the present using a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The selected discount rate is generally based on rates of return available from alternative investments of a similar type, quality, and risk.
Market Approach
This approach measures the value of an asset or business through an analysis of recent sales or offerings of comparable investments or assets. When applied to the valuation of equity interests, consideration is given to the financial condition and operating performance of the entity being appraised relative to those of publicly traded entities operating in the same or similar lines of business, potentially subject to corresponding economic, environmental, and political factors and considered to be reasonable investment alternatives. The market approach can be applied by utilizing one or both of the following methods:
- Guideline Public Company Method (“GPCM”): This methodology focuses on comparing the subject entity to guideline publicly traded entities. In applying this method, valuation multiples are: (i) derived from historical or forecasted operating data of selected guideline entities; (ii) evaluated and / or adjusted based on the strengths and weaknesses of the subject entity relative to the selected guideline entities; and (iii) applied to the appropriate operating data of the subject entity to arrive at a value indication.
- Guideline Transaction Method (“GTM”): This methodology utilizes valuation multiples based on actual transactions that have occurred in the subject entity’s industry or related industries to arrive at an indication of value. These derived multiples are then adjusted and applied to the appropriate operating data of the subject entity to arrive at an indication of value.
- Backsolve Method: By considering the sale price of shares in a recent financing, the equity value can be “back-solved” using an option pricing model that considers the company’s capital structure and the rights of the preferred and common stock shareholders.
Cost Approach
This approach measures the value of an asset by the cost to reconstruct or replace it with another of like utility. When applied to the valuation of equity interests in businesses, the value is based on the net aggregate FMV of the entity’s underlying individual assets. The technique entails a restatement of the balance sheet of the enterprise, substituting the FMV of its individual assets and liabilities for their book values. The resulting approach is reflective of a 100.0% ownership interest in the business. This approach is frequently used in valuing holding companies or capital-intensive firms. It is not necessarily an appropriate valuation approach for companies having significant intangible value or those with little liquidation value.
How often should a private company do a 409A valuation?
Private companies may be required to obtain a 409A valuation before issuing first option grants to employees and shareholders and anytime there is a material event in the company’s lifecycle, like a fundraise or liquidity event (e.g., tender offer).
Some early-stage companies are advised to conduct a 409A valuation every 12 months, consistent with the typical “safe harbor” provided by the IRS (which deems the 409A valuation valid for that period).
Why might a private company hire a 409A valuation firm?
The labor-intensive nature of 409A valuations might be why some private companies choose a third-party provider (like Morgan Stanley at Work) to provide a thorough and independent 409A valuation. Relying upon a trusted 409A valuation provider may demonstrate both the competence and objective perspective that could satisfy IRS requirements for a private company’s safe harbor.
A 409A valuation may provide a private company with safe harbor and secure its ability to grant options and recruit during that period. The job of the 409A valuation provider is to do the heavy lifting on the valuation, provide an analysis that matches the narrative of the private company, help with the messaging to employees, and create a coherent valuation history. Perhaps most importantly, that provider should be absorbing the majority of the work so that the founders can focus on more important things, like building their company.
What is 409A valuation safe harbor?
Proof that a company calculated a reasonable fair market value of its common stock. This will help ensure that the valuation will be accepted as valid by the IRS..
What information does a private company need to provide for a 409A valuation?
Depending on the provider, private companies may need to provide a mix of qualitative and quantitative data. Data points, such as revenue, net income, projected growth, and company/industry risk may be used to make this determination.
How may a private company select my 409A valuation firm?
The key reason why a private company may want its 409A valuation to be conducted thoroughly is so that its equity is accurately priced. A private company doesn’t want to issue options to its employees at one price, only to find out later that the options were under or overvalued. Undervalued stock can hurt the upside of a private company’s employees’ equity, while overvalued stock can quickly lead tax penalties from the IRS (often paid by employees or shareholders), as well as potentially increasing the risk of audit.
How long does a 409A valuation with Morgan Stanley at Work take?
The 409A valuation process has a few stages, which include:
Kickoff (Initial data review)
The valuation team will conduct a thorough review of the data submitted by your startup.
Analysis (Management call)
With pertinent questions in hand, we’ll schedule a call with your team to collect information regarding your business (status and plans), comparable companies, potential risks, and industry insights to be used in the analysis.
Model (Develop draft report and exhibits)
Once we have a clear picture of the business, we’ll complete the analysis and generate the draft report and exhibits.
Review (Review analysis)
We then present the report for your review, collect feedback and make any necessary adjustments.
Finalize (Issue final valuation opinion)
After all questions are answered and assumptions vetted, we’ll present the finalized report.
Once the due diligence process has been completed (information has been provided by the startup for the kickoff), the valuation process generally takes a couple of weeks.
Key takeaways:
- A 409A valuation is an appraisal of value for a private company’s stock.
- This valuation is recommended before issuing any stock/equity to employees.
- An effective way to conduct a 409A valuation is with an outside advisor to establish safe harbor.
- Failure to obtain a 409A valuation can result in tax penalties for both the company and the employee.
