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.

AspectExplanation
DefinitionA 409A Valuation, named after Section 409A of the Internal Revenue Code in the United States, is a financial assessment used to determine the fair market value of a company’s common stock for the purpose of setting the exercise price of stock options or other equity-based compensation plans. It is a regulatory requirement to ensure that employees are not granted stock options at a price lower than the fair market value, which could result in adverse tax consequences. The valuation is typically performed by independent experts and is essential for compliance with tax regulations.
Key ConceptsFair Market Value: The estimated price at which an asset would change hands between a willing buyer and a willing seller, both having reasonable knowledge of the relevant facts. – Equity Compensation: Stock options, restricted stock units (RSUs), and other forms of equity-based compensation. – Section 409A: The specific section of the Internal Revenue Code that regulates nonqualified deferred compensation plans, including equity compensation. – Independent Valuation: The requirement for valuations to be conducted by independent experts or qualified appraisers.
CharacteristicsAccuracy: A 409A Valuation aims to provide an accurate and defensible assessment of fair market value. – Independence: It involves third-party experts to ensure objectivity and compliance. – Documentation: Detailed documentation and reports are generated as evidence of the valuation process. – Regular Updates: Valuations must be updated periodically to reflect changing market conditions. – Tax Compliance: Ensures compliance with Section 409A and avoids adverse tax consequences for employees.
AdvantagesTax Compliance: Helps companies avoid penalties and taxes associated with improperly priced stock options. – Employee Retention: Equity compensation is an important tool for attracting and retaining talent. – Transparency: Provides transparency to employees regarding the value of their equity grants. – Legal Protection: Protects the company and its employees from potential legal issues related to tax violations. – Investor Confidence: Accurate valuations can instill confidence in investors and stakeholders.
DrawbacksCost: Conducting regular 409A valuations can be costly, especially for startups. – Complexity: The valuation process can be complex, involving various assumptions and factors. – Timing: Valuations can take time, potentially delaying equity grants to employees. – Market Volatility: Changing market conditions can impact valuations. – Audit Risk: Incorrect valuations can lead to IRS audits and penalties.
ApplicationsEquity Compensation: Setting the exercise price of stock options and other equity-based awards. – Mergers and Acquisitions: Valuations are often required during mergers, acquisitions, and fundraising rounds. – Fundraising: Providing valuations to potential investors in venture capital or private equity deals. – Financial Reporting: Complying with accounting standards and financial reporting requirements. – Tax Compliance: Ensuring compliance with Section 409A to avoid tax penalties.

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.

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

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The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

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The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

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Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

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A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

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The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

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Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

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