409a Valuations
What is a 409a; why do companies get them; and why do they matter?
What Is a 409a Valuation?
A 409A valuation is an independent appraisal of the fair market value ("FMV") of a private company's common stock. Because the valuation of a private company could be subjective, the IRS provides guidance on key things to consider + acceptable methods of determining valuation (in section 409A of the Internal Revenue Code (IRC); hence the name "409a valuation").
Why Do Companies Get a 409a/Why Do They Matter?
Avoiding Taxes, Penalties, and Fees When Granting Stock Options
The IRS specifies that when stock options are granted, if the the strike price is at or above FMV then no value was given/existed at the time of the grant (and thus no income tax is due). But if the strike price is below FMV, the "discount" is considered value (i.e. compensation) given to the individual, and income tax on the discount is owed.
Avoiding Taxes, Penalties, and Fees When Stock Options are Exercised
If/when individuals exercise their stock options, if the FMV of the firm is greater than the strike price, a "bargain element" exists and income taxes (and tax withholding) are required. As such, a periodically updated 409a valuation is required to correctly calculate taxes for stock options over time as well.
Companies get a 409a valuation so they can appropriately, and tax-correctly, administer their stock-comp plan. A 409a from a qualified independent third party provides a "safe harbor" defense against the IRS (assuming the company complies with the determined valuation).
How Do 409a Valuation Differ From VC-Round Valuations
A 409a valuation, and the value a VC decides upon your company in a financing round are very different. They're conducted by different entities for different purposes, and as such, frequently are significantly different.
VC-Round Valuation: What an Investor Believes the Company Is Worth (But Also Other Things)
When VC firms invest in a company, it can be a highly imprecise. The material majority of VC-backed companies fail, and VC's are many times determining the value of the company based on its future potential, as well as other factors (e.g. how much cash does it need, how much ownership are they getting, etc.). Given that -- one can reasonably argue that the VCs are using more forward-looking valuation methods, and they of course can determine any value they want (there is no rulebook, as compared to the IRS's section 409a).
409a Valuation: A Valuation Required by the IRS (For Tax Reasons)
As noted above, the predominate reason companies get 409a valuations are for tax purposes, and 409a appraisals must use/follow specified valuation requirements and criteria. These guidelines largely instruct the use of more conservative valuation methods like asset, income, and market approaches.
VC-round and 409a valuations can (and typically do) differ significantly; the 409a is usually much lower. This is because they serve different purposes, use different methodologies, are done at different frequencies, and target different values.
The 409A discount disappears when an IPO occurs. As detailed below, 409A valuations of private companies are a fraction of the preferred price. That said, the discount disappears when a company IPOs (because the fair market value is the stock price; and thus 409A valuations are not necessary).
Tax Saving Opportunity. The disappearance of the 409A valuation discount when a company IPOs can provide a significant tax saving opportunity (but requires careful planning).
How Frequently Are 409a Valuations Updated?
409a Valuations Are Valid for a Maximum of 1 Year
This is specified by the IRS, with the clock starting as of the effective date of the 409a.
It's Common for a 409a to Be Updated Prior to 1 Year
If any material events happen sooner than 12 months, an updated 409a valuation is required. That begs the question: "what is a material event?" It can be a bit subjective, but below is a list of events that would typically merit, at a minimum, a company to consider refreshing its 409a valuation:
A new VC funding round
An acquisition/buyout offer
A major financing event (plan to merge or be acquired; IPO)
A major business change (large change in revenue; a major regulatory change; key executive departure)
Pre-IPO 409a Valuations Are Typically Updated Every 6 Months for Larger Companies
As the company grows, the above list of items tends to occur with increased frequency. As such, rather than being reactive to many events, the company will increase the frequency that the valuation is updated
Do Publicly Traded Companies Have/Get 409a Valuations?
In short, no. The price of the company's stock is considered the FMV, and thus a 409a valuation is not needed or necessary.
How Are 409a Valuations Calculated?
The valuation is based on guidance provided by section 409a of the IRS's Internal Revenue Code (IRC). Three of the common valuation methods detailed therein are:
Market approach: Discount Cash Flow analyses; Comparable Companies; Precedent Transactions; Actual Transactions
Income approach: Values a company based on its expected future cash flows and earnings (though many VC-backed companies have negative cash flow and earnings, making this approach uncommon in the startup world).
Asset approach: Values a company based on its net asset value
Want to know more? Diving into further details of how 409a valuations are calculated is outside our intended scope. But if you'd like to know more, we recommend visiting:
Last updated
