Have you identified your right business opportunity? If so, then you might be ready with your business plan. And if your start-up business strategy includes offering shares to the employees of your company, then you will be required to do a 409A valuation.

What Is a 409A Valuation?

The 409A valuation is an essential aspect of a new start-up, if they have offered shares out of the common stock to employees as a benefit. This valuation would give the estimate of the fair market value of the company’s common stock. The common stock is merely equity ownership. For private companies, independent valuations help to show the real value of the assets, so that one can figure out the exact worth of the company’s common stocks.

According to the IRC(Internal Revenue Code section) section 409A, workers can get paid a portion of their income (retirement plans, pensions, and stock options, etc) on a later date. And the 409A name is derived from this section. As a benefit on this income, the taxes are deferred until they are paid out to the employees. This will help the company be more successful if the yearly valuation of your stock options is a part of your business strategy. Thus, the 409A valuation is necessary to reduce a “strike price” which is fixed or exercise price on the underlying assets, and it should be at or above the fair market price.

Why Do You Need a 409A Valuation?

If a company does not hire a third party or an individual to do the 409A valuation, it could not be abiding by the law or the IRS guidelines. The accountant of the company can do the valuation in the initial days of the start-up, but in the later stages, the asset valuation should be done by professionals. Currently, if an employee wants to have the benefit from stock options, they will pay the strike price, which is decided by the valuation process. If the company has not completed the valuation process, then the employee may have to pay significant IRS penalties on their compensations. Thus the 409a valuation ensures that the company works in compliance with tax laws.

When Do You Need a 409A Valuation?

The 409A valuation is required at the time of preparing a business strategy, which includes offering common stock options to the employee. The strike price per share is fixed and provided to the employee as per the valuation of the company’s assets. It is then done after every 12 months or whenever there is a new funding round.

What Factors Influence Your 409A Valuation?

The 409A is the appraisal of the fair market value of the company’s common stock. To determine or estimate the real worth of your assets, the evaluator can follow different approaches such as:

Asset approach: The evaluator will analyze every asset of the company. It may include tangible (like machinery, land, and building, etc) and non-tangible (like a trademark, copyrights, patents, brand recognition, etc.) assets.

Market approach: An evaluator analyzes the equity value using the comparables. For both private and public companies, if the information has existed publically, they fall under the market approach. The information includes the transaction value and the company value. The valuation specialists classify the methodologies into the guideline public company method, the guideline transactions method, and the backsolve method.

Income approach: The valuation specialists analyze the company’s free cash flows and satisfactory revenue and provide the estimated projections up to the next five years using the income-based approach. Valuation experts do not consider the liabilities. Instead, they calculate the revenue generated from the assets.

How Do You Get a 409A Valuation?

There are three ways for generating a 409A valuation report:

Do it yourself: It is an option which does not provide the legal guarantee of the fair value of your business. A business entity may take the help of the company’s accountant for the valuation, which may be subject to error and risks of getting penalized by IRS. As there is no safe harbor protection, a company has to provide proof that the valuation or the strike price per share is accurate.

Use software: There are many softwares available which claim to provide the precise value of the common stock, but opting for this method also make you subject to the various risk factors. However, the use of software can be preferred at the early stages (when the revenue is inconsistent) of startups, since it saves money.

Hire a firm: Hiring a third party or valuation specialists is the least risky option for generating the 409A valuation report. It offers the legal guarantee and safe harbor protection during the IRS audits. It may also save you from potential penalties. It is advisable to research before hiring the valuation experts based on their reputation and experience.

How Long Does the 409A Valuation Process Take?

The estimated time taken by the evaluation experts is around ten to fifteen days to provide a certified valuation report. Before generating the valuation report, the experts make the use of initial, 1 to 3 days for reviewing the capitalization table, also called as the cap table. A cap table is an essential tool for analyzing the company’s equity value and dilution, ownership percentages, whenever the investors, founders or the owners have invested.
Therefore, the company needs to hand over the data (cap table) to the experts along with the financial projections and previous 409A reports, if any. From there the team with conduct the revision and re-verification of the draft, and the final valuation report can be delivered in 10-15 days or so, depending on the complexity of the valuation. You should look for the right, reputed and professional valuation expert.

What Happens if You Don’t Have a 409A Valuation?

Determining the fair market value for stock options is essential as per IRS guidelines. In case the company is not in compliance with government regulations, it can cause significant tax issues. As stated, the stock option holder considered to violate the 409A will have to pay the penalties. Regardless of the taxes, the holder has to pay the 20% federal penalty as well as interest on the unpaid taxes up to that day. It becomes questionable too for the Securities and Exchange Commission. It is advisable not to neglect the 409A valuation and get the safe harbor for your business to avoid such circumstances.

Conclusion

We at IncParadise can assist you for the registration and incorporation of your company. If you have already started up your business entity, and have completed the registration and incorporation process, the next step is to figure out the estimated fair value of the stock options. And now that you are clear about the importance of valuing the strike price of stock and maintaining a cap table, Eqvista can help you in the cap table management of your company with our efficient software.

A well-planned cap table prepared via Eqvista would also be able to help you easily determine the value of your company. Visit our website eqvista.com now, and register yourself to get a 409A valuation report for your company and the cap table management software for future valuations!