What is 409A Valuation & How it Works for Startups

409A is an independent process that is performed during startup valuation. According to IRS rules, 409A valuation must be done by a third-party professional. It is often conducted at the fair market value of a business. During a startup valuation, 409A sets the appraisal price for contractors, advisors, employees and any other entity in a business. 409A startup valuation is performed at the beginning of new financing of investment. Before the introduction of 409A, it wasn’t easy to value a startup. The framework to strike a price for various options was limited.

How Does 409A Protect a Startup and Employees?

  • It guarantees fair market value for option pricing
  • It protects the employees against any legal implication
  • It protects from audit scrutiny when reviewing business valuation

Types of Businesses That Require 409A Valuation

Almost every business in any industry requires a 409A startup valuation. The following are the business that requires 409A startup valuation.

Biotech

Biotech businesses specialize in biotechnology. These companies extract or manipulate their product from living organisms. They include scientific companies such as pharmaceuticals.

Fintech

Fintech business uses modern technology to offer financial services to other companies.

Cybersecurity

Cybersecurity businesses offer network security and prevent intrusion into computer information.

E-Commerce

Ecommerce companies provide a platform for buyers and sellers to interact and conduct business on the internet.

Services

Service businesses help other companies to perform various tasks. These businesses range from legal to healthcare service providers.

Hardware

These businesses manufacture CPUs, monitors and other computer hardware.

Saas

These businesses are mostly referred to as software as service. Their products are mostly software.

Levels of 409A

409A are mostly useful during startup valuation. They provide a price option that is used to reward employees. It is also essential when recruiting new talent for the company. It is important to provide as many shares as possible with the lowest price for long-term employee benefits. 409A provides a framework to add more value to a startup. Valuation is an important tool to combat the risk and other challenges when starting a venture.

Frequency of 409A Valuation

When a business raises its initial capital, it is required by law to perform a 409A valuation. Conducting a 409A valuation during the start of new financial business activity is also required. Most businesses conduct a 409A after the start of each capital raising. The law provides a twelve-month grace period for startups to value their 409A. The only exception to this rule is when a startup valuation reaches an inflection point. Inflection points, such as new financing, often require new valuations.

When a startup has grown to later stages, its legal counsel and auditors usually set a frequency for a 409A valuation. The frequency may reduce from annual to semi-annual and finally to quarterly valuations. When a business reaches a potential IPO, it increases its cadence to about a quarterly period.

A global event such as COVID-19 negatively impacted many businesses. As such, many startups failed to value their 409A. The pandemic resulted in sudden market changes that affected 409A valuation.

Consequences and Penalties of Not Conducting 409A Valuation

Failure to perform a 409A valuation harms employees. The IRS may press more tax charges on the business and employees. When you fail to value your startup, your options might be treated as a taxable income. Moreover, the IRS can levy up to twenty percent after taxes. At this point, the employees might be forced to pay their penalties in cash. The process negatively affects the financial situations of your employees.

Questions on 409A Valuation

Should You Perform 409A Valuation Yourself?

Even if you have all the qualifications and experience, performing a 409A for your business is illegal. An independent party must conduct a 409A startup valuation. If you perform the valuation yourself, you will be risking penalties and other liabilities.

How to Find a Good 409A Valuation Firm

Look at the firm’s experience.
  • Consider the qualifications of the leading staff. Understand their valuation know-how levels.
  • Confirm the number of clients that have exited through an IPO from the firm.
  • Look at the type of companies the firm has worked with.
  • Consider the firm’s experience and its auditing process.

What Information Do You Require For Your First Time 409A Valuation?

When starting your new 409A startup valuation, you need a qualitative and quantitative valuation.

Qualitative Valuation

Qualitative startup valuation provides the hard data of a particular startup. These include:
  • Stage of growth of the particular company.
  • Financial forecasts such as market volatility and potential financing.

Quantitative Valuation

Quantitative valuation deals with the hard data points. These startup valuation points include:
  • Historical business financial statements.
  • The business’s cap table.
  • Latest updates from the business board decks.

Quantitative Valuation

Quantitative valuation deals with the hard data points. These startup valuation points include:
  • Historical business financial statements.
  • The business’s cap table.
  • Latest updates from the business board decks.

What are the Focus Points When Conducting 409A Valuation?

During the early stages of a startup, the start of business financing is the preferred time for a 409A valuation. It provides a benchmark for the financial projection of your business. You can benchmark other similar companies in the early and mature stages. You can study the market volatility and make the right decisions for your business at this time.

What are The Risk Factors in a Startup?

A startup offering new services is likely to encounter problems with product development. Raising enough capital to enable a business to break even is also problematic. An early-stage business might have challenges having positive cash flows.

Conclusion

409A startup valuation is mandatory for any business. The valuation is important for the business and its employees. An independent qualified startup valuer must carry it out. Wiley Financial has experience performing 409A valuations in various sectors. Contact us today for your 409A startup valuation.