In a startup, salaries tend to take up a huge portion of the cash flow. However, it is unquestionable that in order to hire the best talent which can convert a startup into an established firm, money would be required. The answer to this conundrum? Offering equity in business.
Lately, it has become very common for startups to offer equity to attract and retain employees. But while it’s a lot more black and white for a public company, for a private firm it can be challenging to know what the business is worth and how much shares they can offer to their employees. This is where 409A valuation comes into the picture.
What is a 409A valuation?
A 409A valuation is the appraisal of the fair market value of your startup’s common stock. While in the case of a publicly traded stock, it is easy to see the price of a share, for a private company, you would need an independent valuation to know what the stocks are worth.
The origin of 409A comes from the IRS Section 409A, which was added as the part of American Jobs Creation Act of 2004, it states:
“Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.”
Now, before we delve into the concept of what is a 409A valuation and the 409A valuation requirements, it is important for you to know if you should read further.
You should only read the article further, if:
- You are interested to dive into the 409A valuation definition.
- You are valuing the common stock of your company.
- You are issuing the stock options and setting your strike price.
- You have raised a new round of funding.
- You are looking to sell your IP from one company to another.
When do you need to initiate the 409A valuation process?
Generally, there are two events where a 409a valuation is needed:
When you start planning stock options
Imagine this. You have amazing co-founders, your company is built on great ideas and you are ready to scale. The problem? You don’t have a lot of finances for hiring people.
A solution that companies generally find to this issue is offering up stock options to attract employees. But, if you set your new employee with a stock option and the strike price gets lower than what the IRS seems acceptable, you will run into a problem. Problem that oftens looks like a 20% penalty on the valuation to make up for the difference in strike price the appropriate fair market value.
Therefore, the moment you start planning to offer stock options when hiring employees, getting a 409a valuation would become a good choice.
When your company has a material event
Material events are anything which affects the valuation of your company. It can include:
- A funding round
- A merger with other company
- Acquisition of other company
- Acquisition by other company
- Secondary sales of the common stock
- Changes in business model or the financial projections.
What are the most common 409A methodologies?
There are three standard 409A valuation methodologies: market approach, income approach, and the asset approach.
1. Market approach
When the company raises funding, the valuation providers use the OPM backsolve method. In the funding events, it is safe to assume that the investors paid the fair market value for the share and in return they get preferred stock. So the adjustments in common stock and preferred stock have to be made to know what the FMV is.
2. Income approach
For businesses having enough cash flow and revenue, the valuation providers use the income approach. It defines the company’s value as total assets minus liabilities.
3. Asset approach
This approach is generally used for early-stage businesses that have not raised money yet and nor have they generated enough revenue. In these cases, the company’s net asset value is calculated to get to a proper valuation.
What information is needed for a 409A valuation?
Once you’ve planned on performing the 409a valuation process, you will have to share the following data with the valuation provider.
- Name of the CEO
- Name of the external audit firm (if there)
- Name of the legal counsel
- The amended articles of incorporation
- Category of your industry
- A list of comparable public companies.
- The probable timing for a liquidity event
- The count of options you are expecting to issue in next 12 months
- Your business plan, company presentation, and executive summary
- The financial statements
- Forecasted revenue for the next 12 months
- Forecasted EBITDA for the next 12 months
- Cash runway and burns
- Non-convertible debt count
Any relevant events since the last 409A valuation. If it’s your first, a list of the complete history of material events.
How long does a 409a valuation process take?
The time duration of the complete process can look something like this:
Handing over of data
The timeframe of this depends entirely on you. It can be 1 day or 1 month depending on your timelines. This is the stage where you give the data to the valuation provider.
Running the report
Once the data has been shared, the valuation firm runs the report which can happen in anywhere between 10 to 20 days. There are also some firms that can rush the process for a premium amount.
Review the first draft
You get the first draft when the 409a valuation has been done. It now depends on the time you take to analyze it.
It is extremely common for businesses to do revisions at least once or twice once the draft has been shared. This is usually done to get a lower strike price – the price at which the stock option can get exercised.
You will now get the report delivered to you anytime between 1 to 10 days after the revision.
How much does 409a valuation cost?
Some providers offer a standalone 409A valuation service, while others take a bundled approach.
For standalone ones, the 409A valuation price can be anywhere from $1,000 to more than $10,000, on the basis of the size, complexity factor in your business and various other factors, including – how many shareholders you have and the classes of shares, as well as your overall business model and financial structure.
In case of bundled services, the valuation is included with a series of other services that the firm provides.
How can Marquee help?
At Marquee, we offer audit-proof 409A valuations. Having performed over 3000+ valuations, we are the world’s top 409A provider. We make use of the best-in-class technology and expertise to provide valuations a lot faster and for a lot less compared to other providers.
We optimize & accelerate growth for already great products.
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