What is a 409A Valuation?
Public companies are valued by the price their stock trades at in the market, but private companies need a valuation to determine the fair market value (FMV) of their equity. A 409A valuation also establishes the “strike price” (the price at which equity can be bought) that must be at or above FMV.
Why do startups need a 409A valuation?
Since 2004, a 409A valuation is required by law (IRS Section 409A was passed as part of the American Jobs Creation Act) if a private company issues equity or options. Non-compliance can have serious consequences. Undervaluing stock options can result in IRS penalties and lost compensation.
What are the most common 409A methodologies?
There is no universal formula to determine an appropriate value for an illiquid, non-controlling interest in a closely held company. Determination of value is a matter of judgment, which takes into consideration economic and market conditions, as well as investment opportunities that would be considered as alternatives to the interest being valued. The methods commonly used to value a closely held business include the following:
Income Approach
This approach focuses on the income-producing capability of a business. The income approach estimates value based on the expectation of future cash flows that a company will generate – such as cash earnings, cost savings, tax deductions, and the proceeds from disposition. These cash flows are discounted to the present using a rate of return that incorporates the risk-free rate for the use of funds, the expected rate of inflation, and risks associated with the particular investment. The selected discount rate is generally based on rates of return available from alternative investments of a similar type, quality, and risk.
Market Approach
This approach measures the value of an asset or business through an analysis of recent sales or offerings of comparable investments or assets. When applied to the valuation of equity interests, consideration is given to the financial condition and operating performance of the entity being appraised relative to those of publicly traded entities operating in the same or similar lines of business, potentially subject to corresponding economic, environmental, and political factors and considered to be reasonable investment alternatives. The market approach can be applied by utilizing one or both of the following methods:
- Guideline Public Company Method (“GPCM”): This methodology focuses on comparing the subject entity to guideline publicly traded entities. In applying this method, valuation multiples are: (i) derived from historical or forecasted operating data of selected guideline entities; (ii) evaluated and / or adjusted based on the strengths and weaknesses of the subject entity relative to the selected guideline entities; and (iii) applied to the appropriate operating data of the subject entity to arrive at a value indication.
- Guideline Transaction Method (“GTM”): This methodology utilizes valuation multiples based on actual transactions that have occurred in the subject entity’s industry or related industries to arrive at an indication of value. These derived multiples are then adjusted and applied to the appropriate operating data of the subject entity to arrive at an indication of value.
- Backsolve Method: By considering the sale price of shares in a recent financing, the equity value can be “back-solved” using an option pricing model that considers the company’s capital structure and the rights of the preferred and common stock shareholders.
Cost Approach
This approach measures the value of an asset by the cost to reconstruct or replace it with another of like utility. When applied to the valuation of equity interests in businesses, the value is based on the net aggregate FMV of the entity’s underlying individual assets. The technique entails a restatement of the balance sheet of the enterprise, substituting the FMV of its individual assets and liabilities for their book values. The resulting approach is reflective of a 100.0% ownership interest in the business. This approach is frequently used in valuing holding companies or capital-intensive firms. It is not necessarily an appropriate valuation approach for companies having significant intangible value or those with little liquidation value.
How often should a private company do a 409A valuation?
Private companies may be required to obtain a 409A valuation before issuing first option grants to employees and shareholders and anytime there is a material event in the company’s lifecycle, like a fundraise or liquidity event (e.g., tender offer).
Some early-stage companies are advised to conduct a 409A valuation every 12 months, consistent with the typical “safe harbor” provided by the IRS (which deems the 409A valuation valid for that period).
