here are many ways to value a publicly-traded company. You can do it based on a company’s earnings, revenue, enterprise value, or EBITDA (earnings before interest, taxes, depreciation, and amortization).
But for an early-stage company arriving at a valuation can prove to be a bit more difficult. They are young, not nearly as established, and rarely profitable. As such, there’s a lot less information to go on.
Nonetheless, knowing your valuation is very important for an early-stage company (and not just for vanity's sake). Startups need these to properly award stock options, which are a key method for attracting new employees when the company is in growth mode and can’t pay huge salaries. And afterall, you cannot offer equity if you do not know how much a share is worth.
In order to get a proper valuation for this purpose early-stage companies will need to go out and obtain what is called a 409A valuation. So, without further ado, here’s the definitive guide to 409A valuations and an explainer on why they are so important.
What is a 409A valuation?
A 409A valuation is calculated when an early-stage startup hires a third-party company to conduct an independent appraisal to identify its fair market value and stock price.
As we mentioned in the introduction, this will be key when stock options are handed out because the Internal Revenue Service (IRS) does not want startups making up or randomly arriving at their own valuations to make stock options more attractive, or to deceive potential new employees. The IRS also has rules about when these options can be exercised and collected.
More practically speaking, let’s say a startup hires an early employee and gives them a stock option entitling them to purchase 20,000 shares at $5 per share (strike price) with a vesting period of four years. That $5 price cannot simply be pulled out of thin air but is arrived at through a 409A valuation.
Even if a company is private, shares can increase in value because companies are supposed to do a 409A valuation once per year or after a significant event that may impact the company’s value.
How is a 409A valuation calculated?
There are many firms that specialize in calculating 409A valuations and they will usually follow a set of guidelines established by the IRS to arrive at that valuation and determine the stock price of an early-stage company’s private shares.
The firm conducting the analysis will need lots of information from the early-stage company they are valuing. This can include their articles of incorporation, cap tables, company financials, comparable publicly-traded companies, and knowledge regarding any big events that have impacted the valuation.
The appraiser will then spend the next few weeks making three big calculations. The first one is the startup’s enterprise value. This is typically done by comparing the company to similar publicly-traded companies and arriving at a dollar valuation of the early-stage company, similar to a market capitalization of a publicly-traded stock.
These can be calculated in a variety of different ways but often times some sort of revenue multiple is used because EBITDA doesn’t apply to companies that aren’t profitable. Arriving at an enterprise value is easier said than done, however, because the very nature of a startup is to do something that hasn’t been done before, so finding good comparable companies isn’t always so easy.
Once the enterprise value is calculated, then the appraiser will move onto the fair market value of the stock price. This is often a complex process for a venture-backed startup because there are different classes of shares including investors from the various rounds of funding that has been raised, preferred stock, and then common shares. Then an exercise price needs to be determined for each class of stock. Note that the exercise price cannot be lower than the fair market value stock price on the day the options were granted.
Finally, there’s a discount applied to these private shares because they are not as liquid as they would be if they were publicly traded. In this case, the discount typically depends on how close the company is to a liquidation event.
So, if a company just raised their first serious round of financing, there is not likely to be a lot of active buyers looking to buy that company’s private shares. That will lead to a larger discount. But if the company is more established and is nearing a liquidation event such as an initial public offering or an acquisition, than perhaps less of a discount will be applied.
Why 409A valuations are so important for startups
Without correctly calculating and conducting regular 409A valuations, startups can run into legal issues. In fact, more stringent regulations regarding private-company valuations were put into place after the defunct and scandal-ridden energy company Enron enabled key executives to take advantage of deferred compensation policies. The executives, knowing about serious issues within the company, sold their shares while the stock was trading at all-time highs and before Enron crashed and declared bankruptcy.
But now the IRS has developed a set of standards startups and appraisers can use to calculate the fair market value of their shares in a way the IRS deems prudent. If the 409A valuation is done successfully under these standards, early-stage companies can achieve “safe harbor” status. Prior to these new IRS guidelines, private companies had more autonomy in calculating their own stock price. Now, they really have to use independent third-party companies to do the valuations and show their work.
Without “safe harbor” status, startups may be looking at tax penalties from the IRS. Furthermore, it can lead to the deferred compensation of employees getting hit with tax penalties as well, which is not likely to go over too well in the office. It essentially creates a big overhanging potential liability, which is why regular 409A valuations are important.
Do 409A valuations matter to investors?
A fair question. Why? Because the 409A valuations usually aren’t considered when investors and startup founders are calculating pre-money and post-money valuations.
That’s because investor demand is more of a driving factor. Additionally, while the 409A is key in determining employee options for common stock, venture investors typically get preferred stock, which has its own rules and advantages for when investors get their money.
But fundraising can certainly impact 409A valuations because startups are going to get a higher 409A valuation if they just completed a successful round of financing. This raises the fair market value of common stock and its exercise price, which inadvertently raises the exercise price for investors that are paying more for preferred stock.
Finally, as investors you need to make sure that the company you are investing in is in compliance with all of the regulations involving the 409A valuation and is regularly conducting them. As mentioned above, failure to do so has tax implications and could become a thorny issue if raised in the due diligence of a liquidation event. Also, if management is not on top of something as essential as this, it will tell you a lot about their competence.
The overall point of the 409A valuation is to have your company protected from an audit. Other than that, it helps you in protecting your employees from any possible penalties for valuations that are inaccurate.
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