Is your startup looking to expand soon? You’ll need funding from investors. To secure that funding, you’ll have to offer equity.

Before you can offer equity, however, you need to know how much that equity is worth.

Think about it: you can’t issue shares of your company’s stock if you don’t know the total “price” of the company in the first place.

If you’ve reached this point, you’ll need to have a 409A valuation performed for your company. Doing this right can help you acquire maximum funding while avoiding legal trouble.

Continue below to learn the basics of 409A valuations.

 

What is a 409A Valuation?

 

The IRS introduced IRC Section 409A in 2005 as a response to the financial scandals of the early 2000s. Section 409A contains guidelines that private companies can use to determine their valuation and thus calculate the fair market value (FMV) of their common stock.

You need a 409A valuation for your company when you plan on offering equity to investors. You can get one through one of three methods:

• Do it Yourself
  • This method might save you money, but it’s the riskier option. You have to prove to the IRS that your valuation is adequate should they investigate — a difficult and sometimes costly task. The IRS will assess heavy penalties and taxes if they find your valuation faulty.
• Software
  • Less risky, but barely so. You’re still doing it on your own, so you don’t gain any legal protections through “safe harbor” rules (discussed next). Plus, only early-stage startups that meet specific requirements can go the software route.
• Hire a 409A Valuation Firm
  • Hiring a firm is your best bet because it shifts the burden of proof to the IRS. You are protected under 409A “safe harbor” rules, meaning the IRS considers the valuation valid by default unless they can prove the valuation is “grossly unreasonable.”

 

When Do You Need a 409A Valuation for Your Company?

A 409A valuation is valid for the lesser of 12 months or until a “material event” happens. Material events are anything that could impact your company’s stock price — events such as losses of large customers, and superb financial results are good examples. As a startup, financing from investors likely qualified as a material event.

Once that 12 months is up or a material event occurs, you have to get a 409A “refresh,” which is simply an updated company valuation.

How do Independent Appraisers Determine my Company’s Valuation?

 

There are a lot of methods by which you can calculate the value of your company, but appraisers use one of three standard approaches.

• Market Approach
  • Market approaches involve using data from comparable public and private companies to estimate your company’s valuation.
• Income Approach.
  • If you have substantial revenue and positive cash flows, your appraiser may use an income-based approach. Your appraiser estimates the future value of your cash flows to determine your company’s value.
• Asset Approach.
  • With an asset-based approach, your appraiser will analyze the cost of your tangible and intangible asset to arrive at your valuation. An asset-based valuation is often used for early-stage startups that don’t generate revenue and haven’t raised capital.

 

What Are the 409A Penalties?

Failing to get a 409A valuation within safe harbor rules puts you at risk of incurring steep penalties from the IRS. The burden of proof will be on you, and defending your valuation against the IRS is not easy. Penalties for violating Section 409A include:

• Deferred compensation for this tax year and all preceding tax years — except for compensation that is subject to “substantial risk of forfeiture” — becomes taxable immediately in this tax year.
• An additional 20% penalty tax on deferred compensation.
• Accrued interest on the taxable amount of compensation.

As a startup, your risk of IRS audit isn’t high. However, that could increase in the future. Consequently, investing in an independent appraiser will be well worth the time, money, and stress you would’ve spent crunching the numbers and dealing with the IRS.

Questions?

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