409A Valuations for Private Companies

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What Is a 409A Valuation?

Both public and private companies regularly offer deferred compensation to their employees in the form of stock options and retirement plans. The open market determines the value of stock options for public companies. But private companies whose shares aren't publicly traded must rely on different methods to price stock options.

409A valuations determine the fair market value (FMV) of private companies' common stock. Although a company may perform its own valuation, doing so puts itself and its shareholders at risk of severe tax penalties. Thus, businesses turn to independent appraisers for "safe harbor" 409A valuations, which the IRS presumes valid by default.

Safe Harbor Presumptions

The IRS grants safe harbor status to three distinct valuation methods. In the event of an audit, this status ensures that private companies need not defend their appraisal. Instead, the IRS must demonstrate safe harbor valuations to be "grossly unreasonable," a high burden of proof, before imposing penalties.

Safe Harbor via the Independent Appraisals Presumption

Hiring an independent appraisal company to conduct a 409A valuation is the easiest path to safe harbor and, therefore, the most common. Companies should look to reputable firms, like B. Riley, that rely on established valuation techniques to perform the appraisal.

It's essential to find a firm that's truly independent, as conflicts of interest can jeopardize the valuation's safe harbor status. Thus, companies should steer clear of appraisers with a vested interest in the valuation. If the IRS deems the valuation grossly unreasonable, penalties could double shareholders' tax obligations and consequently expose the company to litigation risks.

Safe Harbor via the Binding Formula Presumption

Companies that wish to keep appraisals in-house may still earn safe harbor by valuing their generally applicable repurchase formula. The company must use the same formula to value its stock for all binding agreements, both compensatory and non-compensatory.

Such formulas typically calculate value as a percentage of tangible benchmarks, commonly sales, net income, or EBITDA. Because the binding formula restricts companies from valuing their stock in other ways, most companies pursue alternative appraisal methods.

Safe Harbor via the Illiquid Start-up Presumption

The IRS provides start-ups with an additional valuation method that qualifies for safe harbor. The start-up must be reasonably certain that they will not file for an IPO within 180 days nor undergo a change in control within 90 days. Additionally, this presumption applies only to start-ups founded within 10 years of the valuation date.

If the company meets these criteria, any individual "with sufficient knowledge, experience, and skill in valuing illiquid stock of a start-up corporation" may conduct the appraisal. Such an individual may be an employee or a third party. Regardless of their employment status, they should have a minimum of five years of experience performing valuations or similar work.

How Often Do You Need a 409A Valuation?

409A valuations remain valid for 12 months. Thus, companies should plan on yearly appraisals if they plan to continue offering stock options. However, any material event that affects the worth of a company's stock invalidates previous valuations. Material events might include:

  • Securing a new round of qualified financing
  • Merger and acquisition offers
  • Changes to the business model or cash flow
  • Signing significant, long-term contracts
  • Tightened regulations
  • Substantially exceeding or missing financial projections
  • Considering an IPO

Safe harbor presumptions protect companies that value their stock options at or above their 409A valuation. As a result, it's more important to update valuations after material events that could negatively impact the appraisal.

409A Valuations vs. Venture Valuations

409A valuations determine the fair market value of common shares of stock. Venture capital valuations determine the value of the preferred shares. In most cases, VC valuations will be significantly higher than 409A valuations. This is, in part, because preferred stock receives higher dividends and greater repayment claims in event of bankruptcy.

Before Section 409A of the Internal Revenue Code became law, the value of common shares was often set simply at 10-20% of the last preferred share valuation. Since then, appraisers have developed three widely accepted methodologies for conducting 409A valuations. These methods rely on the company's market, income, and/or assets to determine the fair market value of its common stock.

409A Valuation Methods

Different valuation methods can return dramatically different results. At B. Riley, we often combine these methodologies and employ more sophisticated models to ensure the accuracy of our appraisals. As a result, our reports have consistently proven audit-defensible when scrutinized.

The Market Approach

Also known as the options pricing model (OPM) backsolve approach, the market approach is commonly used to value early-stage businesses and those failing to turn a profit. It relies on the most recent round of financing and financial data from similar public companies to calculate the FMV of common shares.

The Asset Approach

Appraisers turn to the asset approach for early-stage companies that lack financing and revenue. Without a positive cash flow, this approach equates the value of a company with the new replacement cost of its assets.

The Income Approach

Revenue-generating companies are often valued via the income approach. The method appraises the value of a company as the difference between its assets and liabilities.

409A Valuation Requirements

Companies will need to provide all recent financial data when seeking 409A valuations to ensure accuracy. They also need to supply information regarding their business model. When seeking valuation services, companies should have current versions of the following data available:

  • Articles of incorporation
  • Cap table
  • Historical profit and loss statements
  • Debt projections
  • Estimated number of options to be granted
  • Examples of public competitors
  • Details about upcoming or recent material events
  • Marketing Deck

Secure a 409A Valuation Report for Your Company

B. Riley's experienced accounting team will provide your company with an exhaustive 409A valuation report that will stand up to the scrutiny of an auditor. Reach out to us today to get started.