409A Valuations have been targeted in recent years by big box cap table software providers and have been used as a marketing ploy by these venture-backed behemoths to capture clients. The market has been flooded with ultra-low cost “automated” 409A offerings in an aggressive effort to try and consolidate the valuation market and reduce the competitive options for clients. The fundamental issue with these “automated” 409A valuations is that they often fail to deliver a defensible, well prepared analysis and you truly get what you pay for… or less if you include the cost of repricing options and potential tax penalties that you may face in the likely event that the “automated” valuation does not survive an audit! Here are some of the biggest risk factors when using big box “automated” providers:
- They often misprice options as they fail to properly understand a client’s business and related risks due to the minimal amount of time spent on each engagement. Through our experience in audit review, we have seen these “automated” providers make a wide array of grossly incompetent errors ranging from delivering analyses with material calculation errors to inappropriately estimating double the concluded stock price in 6 months when nothing had changed with the business.
- These providers are frequently venture-backed and are primarily focused on maintaining investor returns and searching for an exit. As is the nature with venture backed businesses, there is a good chance they either will go out of business or be forced by investors to drop an unprofitable business line which can leave you holding the bag in the event of an audit. In contrast, Redwood is owned and operated by dedicated appraisers whose only focus is to deliver defensible analyses and will support your valuations for decades to come.
- Due to the “automated” nature of their valuation process, these big box providers have virtually non-existent customer service, which can leave clients feeling unimportant. These providers care more about the statistical impact of your engagement to their sales pitch and pivots to “secondary markets” than spending the requisite time to deliver a high quality valuation. As such, they will not spend the time to understand your priorities as a client to help your company reach its goals.
- Their team of “experts” often do not have a background or significant experience from a qualified financial services firm and the bulk of their work is outsourced to low cost labor overseas in order to maintain their aggressive pricing strategy. In contrast, Redwood employs a team of appraisal specialists with over 100 combined years of valuation experience from industry leading financial services and consulting firms, and proudly maintains a close and personalized workflow with clients.
The key takeaway is that you absolutely should consider getting a 409A valuation if you plan on issuing options in a private company, but if appraisal and accounting services aren’t the core competency of a valuation service provider (i.e. a cap table management company is providing valuations), then you should not use them as they will likely oversimplify your valuation which can lead to a wide array of problems. A qualified valuation provider like Redwood Valuation will collaborate with you to make sure your valuation is performed properly and defended.
What Is IRC 409/Section 409A?
Internal Revenue Code Section (“IRC”) 409A is a complex regulatory framework that was introduced in 2005. It specifies that private companies are required to issue stock option awards with strike prices either at or over the fair market value. Section 409A places different types of qualified deferred compensation into five categories: qualified employer plans, foreign plans, section 457 plans, welfare benefits, and stock options. It also outlines timing restrictions, such as when qualified and unqualified plans can be payable, and the penalties for violating these rules.
IRC 409A also outlines which aspects of a business are relevant to its valuation. This includes things like the value of assets, cash flow, control premiums, and marketability. Understanding these regulations and considering all elements that the IRS weighs is key to avoiding financial consequences, which is why help from a valuation professional is so essential. Complying with IRC 409A also ensures that new startups get off on the right foot, both in terms of complying with federal and state law (where applicable) and laying the groundwork to incentivize or reward employees and attract new hires using deferred compensation.
The IRS implemented IRC 409A shortly after the Enron scandal, where the company’s executives were accelerating payments under deferred compensation plans. This allowed them to access that money before the company declared bankruptcy. Employees and shareholders may now be penalized and fined if a company does not adhere to the regulations outlined in IRC 409A. However, safe harbor status helps avoid these penalties.
Safe harbor effectively means that your company will be protected from IRS audits, as the IRS must accept the valuation unless they can prove that it meets a standard of being “grossly unreasonable.” If a company does not have safe harbor status and fails an IRS audit, they may be exposed to additional taxation, tax penalties, and a full refunding of employee contributions to qualified retirement plans. Further, based on some of the “grossly unreasonable” work we have seen from big box “automated” providers, it would not be surprising to see more employees/companies left exposed to IRS penalties after receiving poor quality valuations from such providers (i.e. providers that focus on cap tables or secondary markets).
What Is 409A Valuation?
Companies often want to grant options to employees as part of an equity-based compensation package. Federal laws require a valuation before doing this to ensure that the exercise price reflects the fair market value. Per Internal Revenue Code Section 409A, a grant with an exercise price below the fair market value triggers a tax penalty.
IRC 409A valuations are uniquely relevant to private companies since public companies have traded market prices that determine the fair market value of the stock used to set the option exercise price. 409A valuations determine the fair market value of common stock in order to price options on common stock and should come from qualified and independent appraisers. Fair market value is defined by the IRS as the price at which a willing buyer and a willing seller, both under no compulsion to buy or sell, each with sufficient knowledge enter into a transaction to buy or sell an asset. As a company reaches its milestones, the periodic nature of these valuations ensure that the business’s fair market value is accurate and up to date.
The IRS regulates 409A valuation standards, and audits are possible. Scrutiny from financial statement auditors or the SEC in accordance with ASC 718 are more likely and also carry significant risks. As such, reputable valuation providers often include or offer audit defense as a service for this reason. Failure to complete regular 409A valuations and adhere to IRS guidelines can lead to tax penalties and other financial consequences including but not limited to a 20% penalty tax and additional interest rate charges based on the date of value.
Note that 409A valuations are only valid for limited periods of time. They expire after twelve months or after a material event occurs that could impact the business’s fair market value. For example, a startup completing a funding round is considered a material event and requires a new 409A valuation to receive safe harbor under IRC 409A .
Generally speaking, a material event is any occurrence that will change the company’s financial condition, business strategy, or mission. Other than closing a funding round, material events include such things as:
- A major merger or acquisition.
- A significant pivot in business or operational strategy.
- Substantially surpassing the forecasted progress associated with an earlier valuation.
- Forging or ending a major strategic partnership with another company.
- Changing the company’s legal status (ex. LLC to Inc.)
- Engaging in the sale of company assets, business units, etc.
If any of these events occurs, you need a new 409A valuation regardless of whether you are within twelve months of the previous one.
Valuation for a private business is determined by an expert who estimates your company’s fair market value. In the event of an audit, the IRS will conduct its own review of your organization’s accounts and information to ensure that its value was accurately reported.
In order to estimate the fair market value of your company, an appraiser will typically rely on one or more of the following approaches:
- Market approach: This approach uses various financial statement metrics of similar enterprises’ equity securities, assets, or investments to estimate the fair value of the Company’s equity securities, assets, or investments. The best determinate for ascertaining fair market value of equity securities of a company is the quoted market price of an active market for the equity securities. By definition, illiquid stock (stock that is not traded on an active market) has no quoted market price. In some instances, a company may enter into arms-length transactions for the sale of its equity securities. These transactions may qualify as a quoted market price and be considered the best measure of fair value provided that the equities sold in the transaction are the same securities for which fair market value is being determined, and the transaction is a current transaction between willing parties (not forced or in a liquidation sale).
- Income approach: This approach derives value by estimating reasonable future cash flows to the firm and/or equity holders and discounting them to present value using a risk-adjusted discount rate or capitalization rate consistent with the riskiness of the forecasts. Limitations under this approach rest on the validity of the forecasts and the underlying assumptions. The income approach is more effective for later-stage companies due to there being an established operating and financial history on which forecasts are predicated. We did not weight the concluded value derived from this approach as discussed below.
- Asset approach: This approach focuses on the fair market value of the Company’s net assets. The approach is most appropriate for earlier stage companies that are in early-stages of development, have small or modest intangibles and goodwill, a relatively small amount of cash has been invested, and where the market or income approaches have no or limited basis.
In selecting a methodology to apply, a qualified valuation firm should consider relevant factors of the business to deliver a meaningful and defensible value estimate. There are no “cookie-cutter” valuations as each analysis must be uniquely tailored to a company’s individual circumstances (hence why using big box “automated” providers can be very problematic). Working with a firm that has sufficient experience and qualifications can ensure that you not only have an updated report in compliance with IRS requirements but also that the methods relied upon are most appropriate for the risk profile of the company being valued.
How Startup Valuation Works
Even if your business is only a small startup, if you offer stock options, you should consider a 409A valuation to receive safe harbor. However, 409A valuations for startups don’t always look the same as those for other types of businesses. In fact, startups present some unique challenges when it comes to valuations.
For example, many startups have limited to no income. This means that it may be difficult to apply a traditional income approach to gauge the enterprise value. Additionally, a startup may not compete in a universally defined industry, and as such, it may make traditional market comparisons within the market approach problematic. In these situations, valuation firms will often employ methods for startups that specifically address these challenges. A couple examples include:
- Backsolve: The Backsolve method (or OPM Backsolve method) calculates an implied fair market value for the company and its stock based upon the company’s most recent round of funding, capital structure, and any other potential financial instruments that the company may hold.
- Cost-to-recreate: This method estimates the cost of building a comparable company from the ground up, including opportunity costs and reasonable profit margins, as appropriate. Popular among investors, this approach assumes that a savvy investor wouldn’t pay more than the standard cost to recreate the assets from scratch to invest in a startup.
While it may be possible for some startup or small-business owners to complete 409A valuations on their own, the risk is generally too high and the methods too complex. Additionally, startups often experience rapid growth or progress through several material events in a relatively short span of time, which further intensifies the need and regularity of audit ready valuations. Given the unique challenges and business circumstances that startups face, coupled with the serious consequences that come with not complying with IRS regulation and guidelines, it is often better to work with a firm experienced in the special valuation techniques that are ideal for earlier stage and rapid growth companies.
The cost of a valuation varies based on circumstances such as the size of the company, complexity of its capital structure, and scope of work. Similarly, the length of time needed to complete a valuation also varies; generally, between two and four weeks. Regardless of time and cost, the most important consideration is that you choose to work with a firm that will help ensure the best possible outcome for your business.
409A Valuation Conclusion
Valuation of your enterprise can be complex, regardless of it you are launching a new startup, growing a closely-held business, or playing a key role in a large, international corporation. There are a lot of valuation charlatans out there, particularly the big box “automated” providers, so it is critical to get valuations from reputable experts with significant valuation experience. If it has been a year since your last valuation or your enterprise has undergone a material event, connect with Redwood Valuation so that we can help guide you through the 409A valuation process.