What is a 409A valuation? It isn’t as easy as you might think. Public companies are valued by their share price. What the public is willing to pay for a share is what it’s worth.
But how do you value a private company that isn’t listed on any exchange especially if you are thinking about issuing common stock to employees, advisors, or investors?
That’s where a 409A valuation comes in. If you need to value your business and plan to issue shares then you’ll need to learn what a 409A valuation is.
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How Much is a Private Company Worth?
If any equity in a company is up for grabs, investors need to know the market value of that equity so they can judge whether they are getting a fair deal.
Likewise, if you own a startup or mature business and investors are offering money for a stake in that business, how can you determine if what they are offering is the right amount?
The answer is to calculate the value and have a 409A valuation in place.
There are different ways to value a company, and both the buyer and owner are going to have different valuations. An owner may skew their value because they have invested blood, sweat, and tears into the business, while a buyer might believe that only one aspect of the business has actual monetary value and then bid accordingly.
In order to find a consensus between these two perspectives, independent appraisers are required.
These professionals look at the history of a business, its debts, its assets, its running costs, and its projections. They may even take the hypothetical future response of the marketplace into account.
When this is performed, a fair market value (FMV) for one share in the business is calculated. This allows both investors and owners to know what a fair amount is.
The Problem with Fair Market Value
Bringing in appraisers to calculate the FMV of business sounds like a pretty simple process, however, it is not. The reason for this goes back nearly 20 years.
You see, in 2001 after the Enron scandal, the business world realized that there had to be a way to stop executives from using false equity valuations. This would close the loophole in regulations which allowed people to either artificially inflate or deflate the fair market value of a company’s private shares.
In order to do this, new guidelines need to be formed. Ones that all appraisers have to follow. And those guidelines are? You guessed it: The 409A valuation.
What is a 409A Valuation?
In 2005, the IRS brought into law Section 409A of its business valuation legislation. This stipulated that a proper valuation of a private company can only be carried out by an independent party. This means that the appraisers cannot have any connection to either the company itself or a potential buyer.
In other words, Section 409A stops unscrupulous businesses from bringing in their own people to deliberately increase or decrease the value of a company in order to maximize profit.
What Happens if I Don’t Use a 409A Valuation?
The bottom line is: If a company is going to offer equity to a potential or existing investor, then a 409A valuation must take place. No ifs, no buts, no maybes.
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If you don’t have an independent appraiser carry out a 409A valuation, and then offer equity to an investor, the IRS can fine you, your employees, your shareholders, and your company.
If penalties are issued after being audited, they will include taxing all deferred monies owed as well as any interest accrued, dating back to the equity purchase. On top of this, an additional 20% tax rate can be added to any outstanding amounts.
When Do I Need a 409A Valuation?
First of all, always seek legal advice from a qualified business lawyer before selling equity in your company. This will keep you on the right track regarding when to carry out a 409A valuation and other legal necessities.
That being said, a general rule of thumb is that you should carry out a 409A valuation if you are considering selling any equity within the next 12 months. A 409A valuation only lasts for this duration and it is especially important if you are planning to issue common stock.
If the 12 months passed and you are still considering selling equity, you need what’s called a 409A Refresh. This is essentially a new valuation taking into account any changes at your company since the previous valuation.
409A valuations and Material Events
If your business undergoes a Material Event during the 12-month duration of a 409A valuation, you will need an immediate 409A refresh.
A material event refers to anything which will affect the fair market value of any hypothetical equity. In other words, if something decreases or increases the value of your business’s private shares, then this is a material event and requires a refresh before any equity can be sold.
Material events include things like new financing, developing revenue streams, new marketplaces, product launches, acquisitions, business model changes, and new performance projections.
If you are unsure at any time whether your business has gone through a material event since the last 409A, consult with an independent appraiser or legal expert.
Learn More About 409A Valuations
I hope this introduction to 409A Valuations was helpful. The appraisal of any business is a critical part of the investment, so it’s worthwhile studying this area before buying or selling equity. In an upcoming article on this site, I’ll be outlining the 409A valuation process in greater detail, along with other helpful business and startup advice.
409A Valuations play a critical role when doing fundraising. In this regard, remember that storytelling plays a key role in fundraising. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the pitch deck template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.