Scarlett Pierce
Oct 12, 2022 2:14:28 PM

How much is a stake in your business worth? Once you’ve gone public, that figure is determined by the market. Private companies, however, are evaluated by other means.

A 409A valuation is an independent assessment of the fair market value of your company’s ordinary shares. The valuation, named after section 409A of the IRS Internal Revenue Code (IRC), also sets the price of a share.

If you’re issuing equity to your employees – even a single share option – you need to determine its value. That’s where a 409A valuation comes in.

In this article, we’ll explain the fundamentals of 409A valuations, and help you assess potential providers. For a thorough breakdown of 409A valuations, read through from start to finish. If you know what you’re looking for, jump ahead to a particular section.

In this guide:

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Do I need a 409A valuation?

If you offer equity to employees or advisors who are US citizens, then you need a 409A valuation. Your 409A valuation should be in place before you issue your first option grants. Even if the US citizens you employ reside outside of the US, you still need a 409A valuation to be compliant with the IRS.

When do I need a 409A?

You should get a 409A valuation:

  • Before you issue your first option grants
  • After completing a funding round
  • Once every 12 months (or after a material event)
  • If you’re approaching an IPO, merger, or acquisition

A 409A valuation is valid for 12 months, or until a material event takes place.

What’s a material event? Anything that affects a company’s value, and therefore its share price.

The most likely material event you’ll go through is “qualified financing”, where your company sells shares or convertible debt to investors.

Other kinds of material event include:

  • A significant, new, or lost contract that represents a material change in revenue, including annual recurring revenue (ARR).
  • An acquisition involving your company as the buyer or seller.
  • Your company receiving a term sheet from a potential acquirer.
  • A strategic partnership that will unlock new markets or improve margins.
  • Regulatory changes that significantly increase or decrease your addressable market.

If you’re unsure whether you’ve been through a material event, consult a 409A valuation provider – you can book a call with us today – or consult your lawyer.

What is IRC Section 409A?

IRC Section 409A was introduced in the wake of the 2001 Enron scandal, during which the energy company manipulated its share price to maximise profits. Regulators responded by implementing measures that stop executives from exploiting equity loopholes. IRC Section 409A was eventually launched in 2005.

Section 409A dictates how private companies must perform their valuations. It also sets out “safe harbor”, meaning that valuations performed by an independent provider – such as Capdesk – are presumed to be reasonable by the IRS.

If you don’t follow 409A guidance, and issue share options that are priced incorrectly as a result, you could be penalised by the IRS. Unfortunately, it’s often your employee stakeholders that bear the brunt of this.

How much does a 409A valuation cost?

The cost of a 409A valuation varies greatly, dependent on the provider and the service agreement. You can purchase a one-off valuation from some providers, such as an accounting firm, for anywhere between £1,000 and £5,000 – depending on the size and complexity of your company.

At Capdesk, 409A valuations are included in the price of our Scale package. The service includes an annual valuation, plus one additional material event-related valuation each year.

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What is 409A safe harbor?

If your 409A is performed in a particular way, it’s given “safe harbor” status. Safe harbor means the IRS presumes your valuation is valid unless they can demonstrate that it’s “grossly unreasonable”.

There are three safe harbor valuation methods, the most common method being independent appraisal presumption. Independent appraisal presumption requires your appraisal to be done by a qualified, third-party provider.

If the 409A valuation is performed within 12 months of the option grant date, and no material events have taken place since then, it’s presumed reasonable. If the valuation is challenged by the IRS, the burden of proof is on them.

What do I need for a 409A valuation?

A range of financial information is used to determine your company valuation, whether you’re performing it in-house or through a provider such as Capdesk. You will need to provide the following data and company insights:

Company details

  • Name of your CEO
  • Name of your external audit firm (if applicable)
  • Name of your legal counsel
  • Your amended and restated articles of incorporation

Industry information

  • Your industry
  • A list of relevant and comparable public companies
  • Fundraising and options
  • Probable timing of a liquidity event
  • Your company presentation, business plan, or executive summary

Company financials

  • Historical financial statements
  • Revenue forecast for the next 12 months
  • Forecasted EBITDA for the next 12 months, from the valuation date to the next two calendar years
  • Cash burn and runway
  • Non-convertible debt amount

Additional details

  • Any materially relevant events since your last 409A valuation (for your first 409A valuation, you’ll need to share a complete history of relevant events)

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409A penalties

If your company valuation doesn’t meet IRS standards, you could be penalised. For your employees and shareholders, this could mean:

  • All deferred compensation from the current and preceding years becomes taxable immediately.
  • Accrued interest on the revised taxable amount is payable.
  • An additional tax of 20% on all deferred compensation is applied.
The truth is, most startups aren’t likely to be audited by the IRS. But as you scale and approach an exit event, the IRS may audit your business. Choosing an experienced valuation provider from the start will save you time and effort in the long run.

Capdesk offers audit-defensible 409A valuations

Through Carta, Capdesk now offers audit-proof 409A valuations. Carta performs 15,000 valuations every year, leveraging proprietary software and industry expertise to perform valuations faster and more efficiently than other providers.

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Find out more about Capdesk 409A valuations today:

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