As a startup owner, have you wondered how to get a certified 409A valuation? Business valuation is a common practice for every business. The valuation process is used to determine the worth of a company at any given time. However, when a company, especially a startup wants to issue stock options, they are required to get a different type of valuation known as a 409A valuation.
There is a lot of talk among startup owners about the complexity of a 409A valuation, however, getting this valuation opens up a whole new world of opportunities for the business. The major reason why startups go for this type of certified valuation is that it makes them eligible to issue equity-based compensation such as stock options to employees.
Employee stock options are commonly offered by startups, and therefore 409A valuation services are mostly availed by new businesses. Startups can get these assessments and then use the findings of the assessment to give their employees an incentive in the form of stock options.
With that said, a lot of startup owners who are getting their first 409A valuation aren’t sure how they can get this valuation done or how it works. In order to make things a little easier for startups, we have created this guide that will explain how 409A valuations work and how you can get it done, so keep reading.
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What is a 409A valuation?
Startups are private entities, which means their shares aren’t publicly traded in the market. So naturally, they can’t rely on the market to set their share price. That is where a 409A valuation comes in, and it can help startups in knowing the fair market value (FMV) of their shares when they want to issue stock options.
409A is a regulation of the IRS that provides guidelines for private companies that they must follow when valuing their share price. It goes without saying that failing to get a 409A valuation when issuing stock options or other equity to employees and executives can result in penalties.
409A valuation needs to be updated every 12 months or sooner if you want to keep providing stock options and other equity-based compensation.
In addition to annual updates, if an event occurs that significantly changes the overall value of the company, then a new 409A valuation becomes necessary. As far as issuing equity is concerned, you can not issue it without knowing how much your company shares are worth. So a 409A valuation is an integral part of the equity compensation process for private companies.
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How can you get a certified 409A valuation?
By now, you should have a decent idea of what a 409A valuation is and why it is important. Now let’s move on to how you can get a certified 409A valuation and what options you can exercise in order to get your company’s stock share value. Commonly there are three ways you can get a certified 409A valuation, and we are going to explain each of them in detail below:
Do it yourself
It is possible for the company owner to perform a 409A valuation as long as they meet the IRS criteria and have the necessary knowledge and skill to perform a successful valuation. It is important to mention that there are no certifications required to become a 409A valuer, so if you think you possess the knowledge, training, and education, you can be your own company’s valuer. The major reason why this option works great for getting a 409A valuation is that it costs a lot less than getting your business valued by an external valuer.
In addition to cost-saving, you have more control over your company’s stock valuation, so you don’t get a lower valuation than the actual value of your company’s stock. While there are perks to this method of getting a 409A valuation, there is a major pitfall associated with this method, and that is the liability of the valuation.
Cons to be aware of.
If there are any issues with the 409A valuation that you performed by yourself, you have to prove the accuracy of the valuation. Not to mention, you may incur penalties if you aren’t sure how to perform the valuation correctly. So by using this DIY 409A valuation option, you may end up losing more than you saved. In addition, you don’t get safe harbor protections if you perform a 409A valuation yourself, which is the biggest drawback of this method.
Since this method of getting your company valued has more disadvantages than benefits, companies rarely use the DIY 409A valuation strategy.
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Using software for a 409A valuation:
If self-evaluation seems too complicated to you, and you don’t want to spend a lot of money on getting a valuation from an expert, then there is a middle way for you. There is plenty of software online that allows you to get a 409A valuation for your company. There are both paid and free tools that you can choose from, and they usually give an accurate valuation for your company.
Even if you buy a 409A valuation software, it will still cost you a lot less compared to hiring a valuator. Not to mention, the process is quicker when you use software instead of a valuation expert. The valuation software can generate a valuation report almost instantly, which can save time and speed up the process of issuing equity compensation to employees.
As a startup that simply wants to get a valuation in order to issue stock options to employees, the software is the easiest way to do so. However, just like the do-it-yourself valuation, there are drawbacks associated with using valuation software.
Cons to be aware of.
For starters, valuation software can’t be used by every business and most reputed software have certain criteria that you must fulfill in order to use them. In addition to the difficulty of usage, valuation software doesn’t make your business eligible for safe harbor protection similar to self valuation.
The drawbacks of using valuation software don’t end here. You can also land yourself in hot water in the event of an audit by the IRS if you use this valuation method. Since the software is not recognized by the IRS, you become responsible for proving the accuracy of the valuation. Failing to provide the required proof can result in fines and other penalties. Due to the drawbacks associated with using valuation software, this method is also not recommended for a reliable and accurate 409A valuation.
Hire a 409A valuation firm:
Hiring a valuation firm or a professional is by far the most convenient, simple, and the most common method used for getting a 409A valuation. Hiring a qualified valuation provider is usually a hands-off process, and they will take care of the complete process of the valuation. So if you are looking for a reliable and simple 409A valuation for your company, then this method is it for you. With that said, it is always recommended to stay involved with a valuation provider during your 409A valuation to make sure the valuation is justifiable in case of an IRS audit.
As mentioned earlier, valuation can be performed by anyone including the owner of the firm. However, the benefit of using the services of a valuation provider to evaluate your firm is the ability to get safe harbor protection for your company. The valuation company that meets all the criteria of the IRS can ensure that your company valuation wins you safe harbor.
In addition, since valuation firms are recognized by the IRS, you don’t have to provide proof of the accuracy of the valuation if your business faces an audit. So by hiring a valuation provider, you can save yourself a lot of trouble down the road. Not to mention, valuations provided by valuation firms are much more accurate than the previously mentioned methods. So by getting an accurate valuation, you minimize the risk of penalties by the IRS.
Cons to be aware of.
With that being said, the drawback of hiring a 409A valuation firm is obviously the higher cost in the form of the firm’s fee. However, the perks of getting a 409A valuation through a third-party valuation provider make the fee completely worth it. A large number of benefits and few disadvantages make hiring a firm for valuation the best way to get a 409A valuation.
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What are the different approaches used for 409A valuation?
Now that we know how you can get a 409A valuation using three different methods, it is important to know what methods are used for the valuation. Since each company that needs a 409A valuation is going to have a different financial situation, the method of valuation also varies. There are three approaches that can be used for a 409A valuation and here is how each of them compares:
The Options Pricing Method
The Option Pricing Method or OPM is a valuation method used to determine the value of a startup that is not yet profitable. Since it is difficult to predict the future outcomes of a business during its early growth stages this approach considers both common and preferred stocks as call options.
When the income approach is used to determine the fair market value of a company the valuation firm takes into consideration the total assets and liabilities of a firm. This approach is only useful for the valuation of companies that have the required revenue and a positive cash flow.
Assets approach: Assets approach is used when a company is not generating enough revenue and doesn’t have a positive cash flow. In this scenario, the valuation firm will consider the value of a company’s assets in order to provide a fair market value for its stock.
How much does a 409A valuation costs?
We have stated that there are high costs associated with 409A valuation multiple times during this article. So you are probably wondering how much you can expect to pay for a 409A valuation. A certified 409A valuation can cost anywhere between $1,000 and $5,000 for small to medium organizations. However, as the size of the business increases, so do the 409A valuation costs. A larger company can expect to pay between $5,000 to $10,000 for a professional valuation.
When a very large corporation needs a professional valuation, the cost of valuation can be even higher than these numbers. So at the end of the day, the cost of a 409A valuation goes up with the size of the company and the complexity of the valuation process.
Spending the bare minimum of $1,000 for a 409A valuation may seem like a lot for startups. So it is understandable for them to consider a 409A valuation a waste of resources and time. After all, startups always have the option to issue non-stock options or NSO to their employees as equity compensation, which doesn’t require a 409A valuation.
At the end of the day, it is up to the company to determine whether the costs associated with a 409A valuation are worth it or not. As mentioned earlier, you can always use free methods such as self valuation or using software to get a valuation report as long as you can defend the valuation in case of an audit by the IRS.
Getting a certified 409A valuation may seem complicated at first glance. However, now that you have read about the various ways you can get this valuation and the costs associated with the process, you can choose the best course of action for your 409A valuation. After all, this valuation is only essential for companies that want to issue equity-based compensation to their employees. So unless you plan on using the equity mode of compensation, you can skip this valuation altogether.
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