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.
In this article, I’m going to explore exactly what a 409A valuation is and why you should care, especially if you are raising funds for your startup.
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.
See How I Can Help You With Your Fundraising Efforts
- Fundraising Process : get guidance from A to Z.
- Materials : our team creates epic pitch decks and financial models
- Investor Access : connect with the right investors for your business and close them