409A Valuation

A 409A valuation is an appraisal of the fair market value of a private company. Conducted by a third-party, independent appraiser, the valuation assesses the company’s common stock that is reserved for its founders and employees.

Understanding a 409A valuation

The 409A valuation was introduced in 2005 in response to the Enron accounting scandal that occurred four years earlier. In essence, the Internal Revenue Service (IRS) wanted to stop company executives from exploiting equity loopholes. 

When the 409A was finalized in 2009, private companies had a framework to follow for valuing their private stock. Since the valuation is performed by an impartial third party, the IRS can assume it to be reasonable under most circumstances.

Startup companies must pay for a 409A assessment before they can set the price at which employees can purchase or receive common stock. For startups, this is often an important part of attracting the necessary talent since the stock is offered tax-free. It also allows the founders to pay their employees in equity when cash is typically scarce.

Why is a 409A necessary?

409A valuations are necessary because the value of a company’s common stock is not publicly available on a stock exchange. As a result, the IRS stipulates that a “reasonable method” of determining free market value (FMV) is performed. This involves an independent assessment of FMV every 12 months.

When these conditions are met, the IRS awards the company “safe harbor” status, which simply means it considers the valuation valid unless proven otherwise. Without this safe harbor, the company may be liable for a substantial tax penalty. Indeed, if the IRS determines that equity was not issued at fair market value, employees may be taxed immediately and fined an additional 20% of their holdings.

When is a 409A required?

As we discussed earlier, a 409A is required every 12 months and whenever a company issues its first round of common stock. These valuations must also be performed when a material event occurs, such as: 

  • Qualified financing – where preferred equity, convertible debt, or common shares are sold to institutional investors at a predetermined price
  • Acquisitions, mergers, and IPOs.
  • Secondary sales of common stock.
  • Missing or exceeding financial projections, and 
  • A shift in business model.

409A valuation methodologies

Independent appraisers typically choose from three standard valuation approaches:

  1. Income approach – for businesses with positive cash flow and sufficient revenue this is the favored approach. Value is determined by subtracting the total liabilities of the company from the total free market value of its assets.
  2. Market approach – when a company requires a 409A valuation after raising capital, appraisers normally use the OPM backsolve method. This is used for complex capital structures where there are multiple equity classes. For example, new investors pay fair market value for their equity while other investors receive preferred stock. In other cases, financial data such as net income, revenue, or EBITDA may be used from similar public companies to estimate value.
  3. Asset approach – the most common approach for early-stage startups that do not generate revenue and have not yet raised capital. Here, valuation is determined by calculating the net value of assets.

Key takeaways:

  • A 409A valuation is an appraisal of the fair market value of a private company. Conducted by a third-party, independent appraiser, the valuation assesses the company’s common stock that is reserved for its founders and employees.
  • A 409A is required every 12 months and whenever a company issues its first round of common stock. They are also required for material events such as mergers, acquisitions, IPOs, qualified financing, and a business model pivot, among others.
  • Appraisers tend to use one of three methods when performing a 409A valuation. These are the income approach, market approach, and asset approach. The type of approach chosen depends on the maturity of the company and whether capital has been raised.
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