6 Important Questions Every Startup Founder Needs to Ask Before 409A Valuation

It is common knowledge that startups issue stock options to attract top talent and bind pay to performance. But do you know how startup founders evaluate the value of common shares? If a company is held privately, the 409A valuation is possibly the only way they can grant tax-free stock options to their employees.Although section 409A of the Internal Revenue Code has remained active since the 1980s, it has evolved significantly over the last 15 years following the Enron scandal. From a string of outdated and helter-skelter techniques to streamlined methodologies, 409A has come a long way.Today, you cannot escape the 409A valuation if your startup intends to grant employees stock options. In this article, we will understand the meaning of the 409A valuation. In addition, we will run through a few things startup founders need to know about the process to avoid complications in their entrepreneurial journey.

409A Valuation: Everything Founders Need to Know

1. What is a 409A valuation?

Broadly speaking, 409A can be defined as a three-step process. In this first step, startup founders calculate the “enterprise value” of the company. The second step involves allocating the enterprise value across different equity classes to determine the common stock's fair market value (FMV). Finally, in the third and the last step, a discount is applied to the FMV, considering that the stock is not publicly traded.

2. What are the benefits of a 409A valuation?

As a founder, it is essential to know that a 409A valuation is critical if you intend to offer equity to employees. Even though many startups take off and become very successful, competing with established companies' benefits is challenging.When you offer stock options to employees, it promises high earning potential and promotes loyalty. However, a 409A valuation is necessary to provide this benefit to your employees without any compliance issues.Apart from attracting the right talent, when this valuation is up to date, it can draw investors toward your startup. After all, the valuable insights extracted during valuation are a vital parameter to highlight the success of your startup to board members and investors. It is also true when your company is not growing revenue or has positive cash flow. Hence, founders should have clarity regarding their business’s worth, making valuation a critical part of that process.

3. When do startup founders require a 409A valuation?

It becomes very crucial to underline the validity of your valuation. Typically, the valuation is valid for 12 months after it was issued. However, when a material event occurs before this one year, the validity changes.What exactly are material events? In simple terms, material events are important changes within a company that significantly impact the valuation. Some examples of a material event include the sale of common shares, acquisitions, divestment, secondary sale of common stock, or a drastic change in the business model.If we are to go by the book, a 409A valuation is required every year after the date of issue or whenever a material event takes place.

4. What information should a founder have to receive a 409A valuation?

A founder should be able to present the following information to receive a 409A valuation:

• Certificate of incorporation
• A company overview which includes all names of executives and an overview of the startup’s industry
• List of publicly traded companies that can be compared to the startup
• Broad estimates of the company’s hiring strategy and options estimate the company expects over the next year.
• Information related to acquisitions, mergers, and the timeline for an IPO
• Any other important events that have occurred since the last valuation
• 3-year debt projections, cash balance, and profit and loss statements
• Most recent pitch deck or a board presentation, especially if the funding round was completed.

5. When do founders need a 409A valuation for their startup?

Apart from the occurrence of material events and the technical requirement of every 12 months, there are a myriad of circumstances where a 409A valuation is highly recommended. Having said that, although it is not an “absolute must”, these situations are important to the success of the founder and the startup. How? The new valuation provides the most recent information regarding the total worth of the startup and an additional data point for growth.Outside the 12 months and material events, founders will need a 409A valuation when:

• Common stock is issued for the first time
• After successfully raising a fresh round of venture financing
• When your startup is on the verge of going public

6. Who can startup founders approach for quick and smooth 409A valuation?

Simply put, the valuation strategy of every startup will differ from the other. Every scenario and startup is unique and brings a different flavor to the overall process. Besides, we can never rule out the evolving nature of the market. Typically, a startup founder should approach their legal advisors and valuation provider to understand the ins and outs of the valuation process and if they need to update their valuation.

Final Thoughts

As a founder, you look out for your startup just like a parent would for their kin. This is precisely why a 409A valuation is essential. Besides, when startups do not price their stocks, in the eyes of the IRS, the business is giving away something precious, leading to tax problems.Although most startups are not likely to face an IRS audit in their infancy, an audit is on the cards when the company starts making profits. Hence, if you are a founder, safeguard your employees and company by getting a 409A valuation.At trica equity, we offer a plethora of services for early-stage startups, including cap table management, stock option management, and valuation management.Get in touch with trica equity to get your valuation certificate at affordable prices.