The startup ecosystem has grown from strength to strength over the past couple of decades. The surge in the number of startups each year has increased competition, compelling companies to find different ways to attract top talent. Most startups resort to stock options to build a team of dedicated and passionate employees.Have you ever wondered how startups calculate the value of common shares or stocks?A 409A valuation is the only way privately held companies can issue grant options on a tax-free basis. Besides, the concept of valuation is extensively used in the startup space across the world.In this article, we will look at some of the key aspects of a 409A valuation report. We have also shed light on why and when companies need a 409A valuation.
Why Do Startups Need a 409A Valuation?
A 409A valuation allows startups to get an honest assessment of their stock and use it to determine the fair market value (FMV).Besides, a 409A valuation can determine the special price for options granted to contractors, advisors, employees, and other parties who receive common stock. Furthermore, tax laws in the U.S. mandate a 409A valuation.Privately held companies can use 409A valuations to comply with the guidelines under section 409A of the IRS tax code, which regulates non-cash remuneration.
When Should Startups Get a 409A Valuation?
Many startup founders find it difficult to determine the best time to get a 409A valuation. There are multiple factors one needs to consider before getting a 409A valuation. However, getting the timing right is critical as it can cause unwanted complications.For example, if you get a 409A valuation earlier than you should, you are burning away precious (early-stage) cash on a service you do not require at the moment. If you get a 409A valuation very late, you are taking the risk of selling unfairly priced stock options, attracting huge fines from the Internal Revenue Service (IRS). Typically, companies prioritize getting a 409A valuation during a material event.The various material events include:
- A qualifying round of funding
- Set up of stock options
- Sale of company stocks in secondary markets
- Major changes in business model and financial assumptions
- Mergers or acquisitions
Understanding a 409A Valuation Report
When you decide to get a 409A valuation, as a founder, it is critical to understand how to read a 409A valuation report. The purpose of this report is to determine the share price for stock options and share offerings.A third-party, unbiased appraiser creates a 409A valuation report that determines the fair market value of a private company’s common shares.Now, let’s examine what is included in a 409A valuation report.
- Valuation Overview and Summary of Key Findings
This section of the 409A valuation includes the report’s conclusion and the common stock’s value. Stakeholders and the management team are largely concerned with this section of a 409A valuation report.
- Capital Structure and Company Background
A company’s background is important as it lays out the history and other vital information about the company.The capital structure typically includes important data regarding a firm’s cap table. The capital structure is thoroughly explained and broken down using charts and tables. This section also includes information regarding the different equity classes and securities that make up a company’s ownership.
- Firm’s Financial Analysis
A 409A valuation includes a financial analysis of the company. This information allows startup founders to make informed decisions related to shares, equity, stock, profit, loss, and revenue. The financial analysis offers clarity on a company’s financial position before the valuation.
- Fair Market Value (FMV)
FMV is one of the key components of any valuation. A 409A valuation report should help you understand how the FMV was calculated. Typically, this information is included in the introduction of the report. It is also important to note that third-party appraisers should ensure that the FMV is calculated fairly.
- Methodology Used to Calculate FMV
The third-party appraiser should be able to shed light on the method used to determine the FMV. In addition, you should also ensure that the numbers included in the 409A valuation report are accurate. Hence, due diligence is very important.Some of the common valuation methods include the market approach, asset approach, and income approach.
- Equity Split
The equity split helps you understand the overall worth of your company’s equity classes. From warrants, stock options, preferred stock, common stock, and other classes of shares, the equity split is included in the 409A valuation report.
Cost of 409A Valuation
A 409A valuation process starts at roughly $1,000 but could reach $10,000 or more for large corporations. Typically, the cost depends on the size of the business, its position in the startup funnel, and how complicated its financials are. The cost of hiring an unbiased appraiser or valuation company will also vary based on the service provider.
Final thoughts
Startup founders should note that deciding to get a 409A valuation is the first step in the right direction. However, they should also be able to understand the contents of a 409A valuation report. The information offers clarity regarding various aspects of their firm’s valuation process.trica offers accurate 409A valuation reports along with transparency. Every report includes all the valuable information mentioned in this article. If you have any doubts regarding 409A valuation and a 409A valuation report, reach out to our team of experts.
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