The 409a Valuation Process

UNDERSTANDING 409A VALUATIONS

Stock options have long been a way for startups to incentivize and retain employees. But issuing them brings with it regulatory requirements.

In the wake of the Enron accounting scandal in 2001, the government started requiring companies to properly value stock options they grant employees. Enshrined as section 409A of the tax code, the rule means that startups need to regularly undergo audits to establish the value of the common shares it hands out as options to its employees.

Steve Liu is Head of Valuation Services at Morgan Stanley at Work, which provides 409A valuations for VC-backed startups, among other professional services. In this capacity, he has overseen the execution of the group’s portfolio of over 10,000 valuation opinions during his tenure at both Silicon Valley Bank and Morgan Stanley at Work.

We recently spoke to Steve about when startups need a 409A valuation, what a 409A analysis entails and what he looks for to determine fair market value for the company and the common stock it grants to employees.

What Is a 409A Valuation?

A 409A valuation is the method by which the fair market value of your company’s common stock is determined. This valuation will essentially determine the strike price for the options you offer to anyone who is issued common stock. In most cases, this will be done by a third-party firm that specifically provides valuations, and will typically occur around major events such as a new financing.

Until the Internal Revenue Service introduced the 409A, startups lacked the framework to price the options they issued. Today, they’re required to value their company and shares so that they know the value of the options they issue their employees.

How Does a 409A Valuation Protect My Business and Employees?

We Read Reports Where Company X Raised Money at Y Valuation. How Does a 409A Valuation Compare?

When a company raises capital, it’s selling preferred shares, which provide a certain level of security for professional investors. The valuations you read about in the media are the post-money value based on the preferred price, not the common price.

Essentially, if there’s a liquidation, debt holders and investors who hold preferred shares are first in line to get back their investments. Preferred shares also typically afford the investor some say in the company strategy. Common shareholders don’t have those privileges. Common shareholders won’t get paid until after a certain valuation threshold has been met. The 409A valuation recognizes that certain benefits simply wouldn’t be recognized by a common shareholder, particularly minority common shareholders. It takes into account all the various rights and privileges that don’t exist with common shares and puts that into a valuation framework. For an early-stage startup especially, there could be a significant difference in value between preferred-share and common-share options being granted out to employees.

Should a 409A Valuation Be High Or Low?

409As are used to price options, and those options are used to reward early employees for their risk and to recruit new talent into the company. Management typically wants to grant as many shares as possible at the lowest price possible to incentivize long-term wealth creation.

We’re sensitive to that. At the same time, an established framework considers the startup’s stage of development and many other things to ascribe value. From that perspective, a valuation can be a science and an art to capture the upside associated with the startup, as well as all the risks inherent to developing a company.

When and How Frequently are Companies Required to Have a 409A Valuation?

Typically, a company will complete its first 409A when it raises its initial round of capital, or any other type of financing (e.g., convertible debt, SAFE). It is also best practice to refresh the 409A value after each subsequent round of capital raising.

Early-stage companies are technically afforded a 12-month safe harbor to grant options at the strike price determined by their 409A. The exception to that rule is when those companies reach some type of value inflection point, like a new financing, which triggers the need for a new valuation. You may have just completed a 409A for your startup, and then closed a new round of capital just a few months later, which would be the typical exception for the annual cadence. Beyond that, it becomes more subjective.

Later-stage companies should expand the conversation to include their auditors and legal counsel to decide upon an appropriate frequency, perhaps moving from an annual cadence to a semi-annual or quarterly one. This is often tied to the anticipation of some kind of exit. As a company is planning a potential IPO in the next 12 to 18 months, you generally see the cadence increase considerably to a quarterly basis.

Another exception is global events like the pandemic. COVID-19 was totally unexpected and it materially impacted many businesses, which ultimately impacts their valuations. When large unforeseen market changes like that occur, this requires at least an additional conversation around whether or not the change you’re seeing is just a temporary blip that has caused the valuation to change. Can you expect that valuation to stabilize in the next 6 to 12 months, or should you hold off doing the next valuation? We explored questions like these and specifically the impact of 409A valuations in the Era of COVID-19 with Steve Liu in earlier conversations this year with The Circle community.

What Are the Tax Penalties or Consequences for Not Performing a 409A Valuation?

Tax implications can be quite steep for employees. If you’re issuing out options that are not at fair market value, the IRS may determine that you owe more in taxes. Let’s say you’ve been pricing options at $1, and the IRS determines that your common shares are actually worth $5. Then, essentially, the difference between what you’ve priced the options at, versus what the fair market value is subject to, will be treated as taxable income. Early-stage companies are technically afforded a 12-month safe harbor. The exception to that rule is when those companies reach some type of inflection point, like a new financing, which usually triggers a new 409A. You may have just performed a valuation for a startup, and they end up closing a new round of capital just a few months later, which would be the typical exception for the annual cadence. Beyond that, it becomes more subjective.

Later-stage companies need to discuss with their auditors and legal counsel to nail down a frequency, usually moving from an annual cadence to perhaps a semi-annual or quarterly one. This is often tied to the anticipation of some kind of exit. As a company is planning a potential IPO in the next 12 to 18 months, you generally see the cadence increase considerably to a quarterly basis.

And it’s not just for the options that are issued in that year. It’s everything — a cumulative amount that includes all the options that have been issued at that Fair Market Value. In addition to that, the IRS can also levy a 20% penalty on top of those taxes. It definitely stacks up. Employees would essentially be forced to pay this tax penalty in cash. They may not even exercise the options, but they’re still paying penalties and taxes associated with them. So, the financial implications for employees can be severe.

New valuations are related to previous valuations, meaning you don’t do these valuations in a vacuum. Part of the new valuation is always based, in part, on the prior valuation, so there’s usually some consistency in terms of the assumptions used from one to the next. If there’s a faulty valuation with one, there’s a good chance that the error could be in prior valuations as well. At that point, it not only impacts the current options you’re issuing, but it could potentially impact many more options down the road.

Ultimately, if you have a valuation that hasn’t been approved or an error is found, you have to go back through the work and re-do the valuation.

The implications are wide-ranging if an error is found with a 409A valuation.

PREPARING FOR THE 409A VALUATION

Should I Do a 409A Valuation by Myself?

Short answer? No. Even if you come from the valuation world and you have all of the proper qualifications, you’re exposing yourself to a big risk and liability, because there’s an independence issue here. It’s the same reason you need an independent appraisal when you’re looking at a loan or mortgage. The bank won’t put much weight on your assessment of the value of your own property. You need someone qualified and independent that’s able to provide a reliable benchmark for the value.

And what’s more, as your company grows over time, the valuation will get a lot more complex. There are many moving parts at play in a valuation that you can easily miss – the chances are very slim of you being able to do a comprehensive valuation on your own, let alone one that stands up to audit scrutiny and protects you from liability. That’s why it’s important to hire a 409A valuation firm.

What Information Do I Need to Prepare for a First-Time 409A Valuation?

The information you’ll need going into a 409A valuation can be divided into two types: quantitative and qualitative. The information below can provide a reasonable determination for what a fair market value for your business should be.

CONDUCTING THE 409A VALUATION

What Do You Focus on Most When Calculating a 409A Valuation?

For an early-stage company, we pay a lot of attention to the rounds of financing. When you have professional investors pricing the round, it serves as a benchmark. Beyond that, we’ll look at financial projections, knowing that they’re easier to benchmark against public comps for a mature company and that for earlier-stage companies, there’s significant volatility in the forecast. The preference stack in the cap table (for those startups that have raised capital) also needs to be factored into the valuation.

What Key Risk Factors Do You Look For in a Particular Company?

Some of them are market-related. Most of our clients are in nascent markets, offering new products and new services, so risk is associated with product development. We consider the competitive landscape. We look into whether the company has raised enough capital to reach breakeven or reach positive cash flow. And we consider how the market responds to the company’s products or services directly relevant to its growth prospects.

When you’re working with later-stage companies, factors such as unit economics start to play a much larger role. We try to assess the path to profitability

What Standard Methodologies Are Used in a 409A Valuation?

The valuation methodologies are, to some degree, correlated with a company’s stage of development. If you think about earlier stage companies — everything from a business model that exists only on the whiteboard to the company that’s just started some product development — they’re probably not generating much revenue, if at all. They may not have raised significant capital at that point or even raised an institutional investor-led round.

So, you’re generally relying upon any capital that has been raised and associated pricing indications. There’s also a cost approach, in which you’re looking at what’s been invested and how it relates to the IP that’s been created to come up with a value for the company.

Generally speaking, these are for nascent companies that are often pre-revenue. They may not have raised much capital, so what’s available is based on the identifiable assets.

Usually, when a company is starting to generate some revenue, you can apply a market approach based on forecasted growth and/or profitability.

At this point, you’re trying to benchmark the company to publicly traded companies. This allows you to look at peer companies that either has a business directly relevant to your startup or at least have relevant adjacencies. You can then benchmark the company, either on a revenue or EBITDA/EV basis. If a company is starting to become cash flow positive, you can use EBITDA/EV multiples.

You can also consider using a discounted cash flow approach. This is likely the most robust way of valuing a company. However, it’s also the most challenging because many assumptions go into your cash flow analysis, and this method presumes that you have a reliable forecast.

If you think back to the early-stage company, they’ll typically have a hockey stick-shaped forecast. There’s a lot of volatility, so it’s hard to use that type of forecast in a discounted cash flow analysis. We generally see the feasibility of using that type of approach for later-stage companies.

There are a number of allocation methodologies used for that second piece. For early-stage companies that may only have common equity, it may be a simple arithmetic calculation of dividing the common shares to arrive at a fair market value.

For most companies that have some preferred shares, you’ll use an option pricing model (OPM), and the large majority of 409A valuations use an OPM to allocate value.

For later-stage companies, we sometimes use scenarios to model out a potential IPO or an M&A event. The AICPA practice aid calls it Probability-Weighted Expected Return Methodology (PWERM).

Simply put, the PWERM consists of scenarios built into the 409A. You can use that alongside the OPM. This gives what we call a hybrid approach, where you use the OPM and PWERM together. Again, this reflects the diversity of startups who are in different stages of development and have a shorter time horizon to exit.

How Does Secondary Trading Impact the 409A Valuation

It has become increasingly common for private companies to conduct secondary liquidity programs to reward their shareholders with partial liquidity. In these situations, the 409A valuation typically will act as a guidepost for pricing these secondary transactions; but ultimately, the strike price is determined by the company and/or the buyer.

Secondary activity can and often will impact future 409A valuations.

For earlier-stage companies where one or two individuals (the founder or one of the original employees) are liquidating their equity, the liquidation won’t move the needle on the 409A. But ultimately, the 409A pulls in various benchmarks of value, from investment rounds to financial performance to secondary transactions. But it’s important to parse out the circumstances under which the secondary transactions were completed.

As a general rule, the “closer” a buyer is to the company (e.g., access to information, level of due diligence, board representation), the higher the potential impact of that secondary transaction is on the 409A. Using that rationale of an “informed investor,” current investors could have a better understanding of the risk/reward profile of the startup than an outside investor. Of course, as one might expect, there are many permutations (and other considerations including the stage of development, sales frequency, and buyer/seller-specific incentives to purchase/liquidate) so ultimately, each secondary transaction has to be evaluated on its own individual merits.

Common Myths About 409A Valuations

Myth: There’s a Rule of Thumb for Where Your Common Value Should Be, Based on Your Stage of Development

In the early days when the industry was unregulated, common was assigned an arbitrary value (such as 10% of preferred). This approach laid the groundwork for the establishment of 409A guidelines because it’s impossible to come up with a value without actually doing the analysis. Ultimately, the valuation is dependent on a multitude of factors and also impacted by company-specific factors. For example, when you consider a financing event—how much capital was raised, what were the terms, how much was raised, how much equity did the investors take? All of those details have a material impact on the valuation.

No startup is a carbon copy of another, and because there’s diversity in terms of each company’s path to success, that impacts your valuation. The specifics of a company’s performance and their industry also plays a role in the valuation. It’s a common fallacy to think that if you’re a Series A company, your common should be 20% of your preferred. It’s literally just a number you’re pulling out of a hat at that point. You may not be wrong, but ultimately you have to do the valuation to determine whether or not your guess was correct.

Myth: You Are Not Required to Issue Out Options at the Concluded Price

If you think back to the 409A valuation and its purpose, the IRS was essentially trying to prevent companies from issuing out options that were in the money. To qualify as nontaxable income, the options need to be issued at fair market value. It also gives management the ability to issue out options higher than the 409A price. We observed this more frequently with Covid-19, as there were temporary blips of value decreasing.

An important aspect of the 409A valuation is the message you’re sending to employees. If they see the company value decline, it could erode their confidence in the business. That may be an unnecessary erosion because it’s a temporary phase the company is going through, and management has a plan to stabilize the business.

When we talk about repricing options, it’s important to consider whether the problem is temporary or permanent. When you see a downward trend on a 409A valuation, you may want to continue to issue options out at the prior 409A, if only just to help employee morale and show a reflection of the confidence management has in the business and the expectation that the valuation will eventually recalibrate to what it was before.

This also has implications for recruiting purposes. As you’re recruiting for talent and looking at the valuation, you certainly want to create upside, but you also want to create a true narrative around the company and how it’s doing. Here, the 409A valuation provides you with a floor to issue out options, but it doesn’t bind you to that price.

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