A 409A valuation process is used to evaluate the value of shares that your privately held firm can give to its workers in the form of tax-free stock options. It’s critical to be meticulous in obtaining an accurate, detailed 409A value for the benefit of your business and to prevent IRS problems. In this article, we will see what 409a valuation methods we can use to avoid IRS issues.

You’ll need to budget enough time to acquire all of the necessary information and resources and finish the valuation. To avoid fines, if you decide to employ a business to undertake your appraisal, make sure you choose a competent firm with a solid reputation.

All You Need To Know About The 409a Valuation Process

The first stage in a 409A valuation process appraisal is to determine the enterprise value. The second stage is to divide the enterprise value across multiple equity classes, yielding the common stock’s fair market value. The third and last stage is to deduct a reduction from the fair market value in order to account for the fact that the firm is not publicly listed.

Stage 1: Determining the Enterprise Value: The Three Approaches 

The market approach, the income approach, and the asset approach are the three most often used 409A valuation methodologies. The market method employs financial data from comparable firms, such as sales, net income, and EBITDA.

The Market Approach is utilized for early-stage or unprofitable businesses when long-term financial performance is impossible to forecast. The OPM backsolve method is one of the methods within the Market Approach that takes into consideration the fact that new investors pay fair market value for their shares while existing investors get preferred stock. The fair market value of common shares is factored into the market method. The other methods include ‘Guideline Public Comparable Method’ and ‘Guideline Company Transaction Method’
409a valuation

The Income Approach is for organizations with enough revenue and a solid cash flow, valuation experts prefer to employ the income approach.

The Asset Approach is frequently used by valuation firms for enterprises that do not produce income and have not yet obtained funds. To arrive at the right valuation, this method employs the net asset value. The quantity of total assets is subtracted from the equivalent liabilities to arrive at the company’s fair market value.

Valuation providers may utilize these three methodologies in combination with one another as firms develop and evolve, and they may adjust their methodology as organizations mature.

Stage 2: Allocation of the Enterprise Value

Certain economic rights, such as liquidation preferences, participation rights, and conversion ratios, must also be considered by valuation providers.

Essential Pre-Requisites of a 409a Valuation

Independent Valuation

The most frequent technique to comply with Section 409A is to have the value done by an independent, competent appraiser from outside the company. The third-party appraiser must have full access to the company’s common stock in order to make an evaluation and take into account all relevant facts.

Valuation should include a list of five or more companies 

A comparison of your firm to comparable companies is used as part of a 409A valuation. As a result, you should include a list of five or more organizations in your valuation that you believe are important and comparable to yours. Don’t worry if your business doesn’t fit neatly into one of the categories. The IRS is used to scrutinizing businesses that cause market disruption. Keep in mind that the comps you select will be used in all subsequent 409A appraisals, so make sure they make sense. You should only add fresh companies when highly comparable firms go public.

Inside Valuation of an Illiquid Startup

An internal valuation may be appropriate if a company is not yet big enough or established enough to pay the fees of an independent appraisal. A firm must meet the following criteria in order to use the illiquid startup insider valuation safe harbor method:

  • Been in business for ten or less than 10 years
  • No publicly traded securities
  • There is no realistic expectation of being bought or going public in the next 90 days; and
  • There are no put or call options or other comparable obligations on common stock.

Financial Statements

You should include your expected revenue and EBITDA for the following 12 months in your financial statements, commencing from the valuation date and continuing for the next two calendar years. Include a three-year profit and loss statement, debt predictions, and cash balance in your financial statement. Because they don’t have enough history to be very accurate, new firms merely need to give it their all.

Conclusion

Obtaining a fair assessment that you can confidently defend is a lot of work. That is why the 409A valuation process should not be taken lightly. Startups are seldom audited by the IRS at random. Regardless of your dedication to establishing your company from scratch,  the IRS will penalize businesses that can’t justify their values. The time and money you spend hiring a respected 409a valuation company are well worth your time, effort, and money.