Being a founder comes with loads of responsibilities, but that’s the exciting bit about the entire company ownership. Among many aspects that a founder must manage, compliance and company valuations are two of the most critical.

More specifically, 409A valuations are one of the essential elements that guarantee your company’s success in the longer run.

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So, in this post, we will take you through the 409A Valuation, the requirements, advantages, and other essentials. It will help you pick the relevant compliance tools and valuation providers you can trust.

What is a 409A Valuation?

409A is a section of the Internal Revenue Code, established in 2004 under the American Jobs Creation Act. The reason behind section 409A was to make it clearer to company owners about the rules related to the non-qualified deferred compensations. It includes 409A stock options as well.

Primarily, the 409A came after the Enron Scandal. The scandal found several corrupt executives of different companies converting their deferred compensations into cash just before their companies went bankrupt.

Therefore, the 409A focused on deferred compensation and the issues surrounding their exploitation, especially related to company equity.

With 409A Valuations, companies can understand their fair market value (FMV) and common stock. Thanks to the Internal Revenue Service (IRS) regulations, there are comprehensive frameworks to determine market value. Moreover, there is a lot of flexibility and companies can choose from various valuation methods.

Whether it’s a public company or a private firm, it’s essential to know the worth of a piece of your company. This is where 409A valuations help owners to figure out the company’s stock value. But, more importantly, these evaluations can help you address the factors that should increase your company’s worth.

When is 409A Valuation Essential?

If you have valuated your company before, remember that your 409A Valuation will be valid for 12 months from the effective valuation date or the validity ends when a material event occurs. Material event is any event that can affect a company’s stock price.

Generally, a qualified financing event is a material event for most startups in their early stage. Qualified financing involves selling common shares, equity or convertible debt to institutions or independent investors.

However, a material event isn’t only limited to financing. It may also depend on divestitures, acquisitions, secondary stock sales, and modifications in business models. But often, it’s not easy for companies to determine whether an event is material or not. So, it’s best to take services from 409A valuation providers to understand the nature of the event.

Typically, companies require a 409A valuation when:

They have raised a round for venture financing
They are ready to issue their first standard stock options
Approaching a merger, acquisition, or IPO
Completion of 12 months after valuation or after a material event

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Requirements for 409A Valuation Report

A 490A valuation report is in order whenever a company is required to have a 409A valuation. So, according to the IRS rules, companies must open their essential information to an external auditor who shall review each document thoroughly during the 409A valuation.

We will discuss the essential information for 409A Valuation later in this post.

Moreover, companies can also outsource the 409A valuation reports to third party operators. Generally, it’s a better option. Most third-party valuations provide a presumed ‘safe harbor.’.

It means that the valuation carried out by the third party is reliable and can be trusted for further process. Find out more on safe harbor later in this post.

Required Information for 409A Valuation

To prepare for a 409A valuation, you need to arrange some essential information about your company. Typically, it involves legal and financial details. So, whether you are preparing an in-house report or an outsourced one, you will need to provide the following information to your auditors to help prepare a comprehensive report.

Company Details

It starts with the essential details about your company. The report requires you to mention:

Name of the company CEO
Name of Legal Counsel
Names of the external auditors (if applicable)
Amended and restated incorporation articles of the company

Industry Details

Next, you will provide the details of the relevant industry. So, provide the details of the business sector in which your company operates. Here is what you must provide:

Your business sector or industry
List of competitors or comparable companies from the public domain

You must provide relevant or comparable companies because the 409A valuation depends on a comparative analysis. Auditors prefer evaluating relatable details from the public sector companies.

Fundraising Details

Now, the auditors will look for fundraising details. They analyze your fundraising options, so you must provide the following:

Probable time for a liquidity event
Options you are likely to issue in the next year
Business plan, executive summary, or company presentation

Financial Information

This is a critical part of your valuation. Here, the auditors will look for the financial details of your company. Here is what you must provide:

Company’s financial statements
Income statements for the last three years
Balance sheet statements
Cash flow statements
Debt projections
Forecasted revenue for the next year
Forecasted EBITDA for the next year
Amount of non-convertible debt

More Miscellaneous Details

Furthermore, the auditors may ask you for additional information which they feel is critical for your company’s valuation. Typically, the additional information includes:

Any previous material events since your previous 409A valuation
History of events for first time 409A valuation
Latest capitalization table
Expected stock options that you may issue within the valuation period

Generally, many companies rely on software-based solutions to manage equity-related procedures to ensure better compliance. For example, these are typically helpful when companies outsource the auditing process for higher chances of success with their 409A valuation reports.

409A Valuation Methods

There is no single method to acquire a 409A valuation. Instead, companies have flexible options in choosing their preferred valuation and reporting methods. Typically, three approaches are most frequently used. Here is a look at them.

1. OPM Backsolve – The Market Value Approach

The market value approach may use any approach to conclude a fair market value for a company. Typically, when companies close an investment round in the near past, it is assumed that the investors paid a fair market value for whatever equity they have purchased from the company.

This approach considers that venture investors have received a preferred share value. Moreover, it predicts a fair market value based on a formula that primarily focuses on common stock.

Also, a market value approach may involve assessing the public companies belonging to the same business sector. Auditors may be inclined to assess the value of these companies to arrive at a fair market value for the company under discussion.

Of course, auditors adjust the numbers according to the size, revenue, and target market of the public companies that they assess for reference.

2. Income Approach

This approach focuses on the revenue generated by the company. So, auditors analyze a discounted cash flow to estimate the net worth of the current cash flows. Moreover, they can analyze the expected revenue for the company in the recent future.

So, the expected income is the sole parameter to predict a company’s valuation. That’s why companies with larger revenues and well-established cash flows are likely to choose this method for their 409A valuation.

The income approach doesn’t work well for startups and growing businesses because they don’t have many expected income streams to show to the auditors. So, if you don’t have a steady cash flow and don’t expect it in the near future, the income approach can lead to a lower valuation of your company.

3. Asset Approach

In the asset approach, the auditors look at the net assets of your company. So, it’s ideal for startups and early-stage companies because they don’t have any raised money. Moreover, they are less likely to have launched products and have no substantial income streams yet.

409A Safe Harbor

Your 409A valuations are sent to the IRS, which further analyzes the report to consider it reliable and grant you the proposed valuation. So, it means that the valuation report must come from reliable sources. This is what safe harbor is all about. When auditors handle your report in a certain way, the evaluation may be eligible for a safe harbor.

You can rest assured that the IRS will not question your valuation and presume its validity. Generally, third-party 409A valuations come under safe harbor because third-party auditors are involved.

However, if the IRS considers your valuation unreliable, it will term your valuation as ‘Grossly Unreasonable.’. But how do you ensure that you’re at a safe harbor?

According to the IRS, there are three safe harbors to set a fair market value for private companies. They are:

Binding formula presumption
Independent appraisal presumption
Illiquid startup presumption

Generally, the independent appraisal presumption is most commonly used as a 409A safe harbor. What does it mean for the companies? They must appoint third-party appraisers to analyze and report to the IRS.

Moreover, when a stock is valued within a year of the previous grant, and there has been no material change, a 409A valuation is presumed reasonable. So, if you can successfully fulfill these requirements, the IRS must prove the valuation is grossly unreasonable. Otherwise, it will be considered reasonable.

Benefits of 409A Safe Harbor

The 409A safe harbor has some obvious benefits. Unlike a self-run financial analysis, approaching via a safe harbor prevents complications further down the road during a 409A valuation.

Generally, when companies determine their fair market value through self-run financial analysis, there is a limited element of reliability. However, most companies during their early days use self-analysis. But this analysis can become more complex with time as the company starts generating revenue and there is a better cash flow in and out of the company.

As a result, there is a bigger need for expertise, and managers need to dedicate more time to complete such reports. But on the other hand, safe harbor approaches use third-party valuation providers. It ensures that your 409A valuation is filed in due time, so you can avoid penalties from the IRS.

But this is possible if your company has completed a 409A valuation in the previous 12 months. Otherwise, the IRS will term your valuation as grossly unreasonable, which would result in penalties. In addition, it may lead to fines and taxation on the options.

409A Valuation and Common Stock Fair Market Valuation

409A valuations essentially figure out the fair market value of your common stocks. Therefore, firstly, it’s critical to understand the difference between the valuation by the investors during a fundraising round and a 409A valuation.

With 409A valuation, the fair market value is evaluated for your company’s common stocks. Therefore, it’s typically a third-party valuation. Such a valuation will dictate the strike price for the available options to your employees, advisors, contractors, and others eligible for common stocks.

Generally, 409A valuations can be different from a post-money valuation of a company. The post-money valuation is based on the investors’ pay to buy the ownership stake during a fundraising round.

As investors avail of preferred stocks, the post-money valuation will be based on the preferred shares’ price. On the other hand, 409A valuation is for common stock. Generally, preferred stocks have more value than common stocks, so these two valuations will always yield different outputs.

What is the Cost for 409A Valuation?

Depending on the valuation features, the cost of 409A valuations can vary substantially. Some valuation providers provide bundled services, while others are strictly standalone services.

Generally, a 409A valuation can cost around $1000 to $10,000. It depends on the company size and how complex your valuation process may be.

Therefore, ensuring compliance throughout the year and maintaining essential documents can make your valuation process smoother and less costly.

Also, many services offer cap table management and equity handling services. So, they allow clients to view their complete audit trail and track changes during the company cycles. These services are quite handy for your 409A because they ensure compliance and make your job much easier during the audits.

409A Valuation Renewal

409A valuations are due every 12 months and even sooner in some cases. For instance, if you have a qualified financial round during the valuation period or a material event, a new 409A valuation becomes due on your company.

But if you don’t know what events force a 409A valuation renewal, here are some of them:

Before you offer your first stock options to employees, advisors, and others.
When you raise a funding round in venture financing, your previous 409A no longer stands. So, you will need a new one.
After any material event that is likely to affect your company’s stock value.

409A Valuation Penalties

If you don’t follow an approved method for your company’s valuation, you may not make it to the safe harbor for 409A. This means you may be eligible for penalties. Therefore, it is critical to carry out valuations through one of the methods that we have discussed earlier.

These penalties include:

Additional 20% tax on the deferred compensations
Revised taxable amount and accrued interest
Deferred compensations from the previous and current years
Additional penalties due to understating their income
State-imposed penalties

Therefore, even though it may not be necessary for startups to use a reliable valuation service, it’s good to use third-party evaluators. This keeps you from sudden compliance hiccups, especially after you experience a material event, merger, IPO, or acquisition.

So, when you consistently use valuation services for your company, it can help you during IRS audits and save you from penalties.

Who Pays for 409A Penalties?

Everyone who is a shareholder in your company will be penalized. This means your employees, advisors, and other shareholders will pay the penalties when you fail to make it to the safe harbor.

The penalties can prove to be quite enormous for individual employees and shareholders, which means that it’s important to use complying tools for your 409A valuations.

How to Avoid 409A Valuation Penalties

Generally, an IRS audit is very tough, and it could result in penalties. It can be difficult for the employees when their company doesn’t strive to prevent these penalties. Therefore, companies need to stay clear of some crucial mistakes to avoid an IRS audit in the first place.

Here are some things that could keep you from an IRS audit:

Make sure to prevent quicker payouts for the non-qualified deferred compensations (NQDC).
If participants wish to reduce their NQDC payouts, it can lead to mismanagement of NQDC forfeitures. So, it’s important to avoid this critical mistake.
Don’t allow your employees to change their status from full-time to part-time unless they account for the necessary regulations that segregate the two service forms. Otherwise, it can trigger NQDC payouts.
Don’t allow participants to delay NQDC payouts unless they adhere to the rules that permit any payment delays.
Avoid using any SAR strike price less than your company’s FVM.

In addition to these preventive measures, it’s important to double-check compliance to ensure that you reach a safe harbor. So, reviewing the NQDC plans is a great place to start. It helps you to prevent any risk of missing a valuation and ensures better compliance with the 409A.

When you review your deferred compensation plans, consider the following in detail:

Payment acceleration
Payment timing
Fair Market Value
Payment re-deferral
Initial Deferral Election

Using Audit Management Software to Ensure Compliance

Handling the compliance matters and ensuring smooth operations management can be a tedious job, especially if you’re not using the right tools. A software-based approach can help you streamline different processes and reduce the risks attached to your equity management.

Therefore, it’s important to seek an equity management software that ensures the following:

Reduce Time Spent on Low-value Manual Processes

Equity management often requires intense activities, which can conflict with your day-to-day responsibilities at your company. For instance, stock grant refreshes, periods of rapid growth, financial reporting and filings can consume a considerable portion of your day.

Therefore, software that can take care of such administrative tasks will ease your work and help streamline operations to a great extent.

Scale with Your Business

Often, equity management platforms lack scalability. So, once the businesses start scaling, they can face hindrances from their management platforms. When a company starts growing, tracking and managing its equity plans becomes even more critical.

So, a scalable platform becomes a necessary choice for such businesses if they want to avoid complications in the future.

Reduce Financial Compliance Pressure

Manual processes may create problems during your equity plan administration, so they aren’t always reliable. Manual processes are likely to miss out on details that can prove costly for a company during 409A valuations.

Therefore, you need software to manage your cap tables, financial disclosures, equity plans, etc. Moreover, it’s much less time consuming than manual operations and gives you the ease of integrating across different systems.

With these software solutions, you can say goodbye to Excel-based reporting and revolutionize your 409A valuation process.

Automate Stock Administration

Some of the best software tools allow you to automate stock and grants administration. For example, you can take up an administrative role, and your shareholders can access a portal having ready to use reporting tools. This helps automate reporting and other manual processes through a web-based platform.

More importantly, it ensures higher compliance that will help you during your 409A valuation.

Conclusion

409A valuation is essential for companies to determine their fair market value. It’s a strict set of auditory protocols that ensures higher compliance with the financial regulations in the country, making it an even playing field for everyone.

With flexible valuation methods and safe harbor options to choose from, the 409A practices can help businesses understand their true worth.

They need to ensure timely practices to avoid penalties and financial drawbacks. Therefore, the role of compliance and management software becomes critical to help businesses achieve a safe harbor and ensure industry-standard reporting for the IRC.

Learn More About Equity Management Software

The post Guide to 409A Valuations appeared first on insightsoftware.

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