Due to the frequency with which a company is required to perform a 409A valuation, growth company founders should take care to avoid the most common pitfalls.
To do that, our team at Kranz has outlined some essential information regarding 409A valuations, the most common pitfalls, and the three steps we advise our clients to take to establish success.
What is a 409A valuation and why is it important?
A 409A valuation is an estimate of the fair value of a private company’s stock. The name of these valuations comes from the section of the Tax Code that require a company’s stock options be issued at their fair market value to receive favorable tax treatment.
Any time a company grants stock or stock options to employees or others, it needs to have a valid 409A valuation. A proper valuation performed by a qualified, independent appraiser provides a safe harbor for the holders of the stock or stock option grants to prevent the recipients from being taxed.
Common 409A valuation challenges for founders of startups and emerging growth organizations:
- Difficulty projecting future cash flows due to limited financial history.
- Monitoring and ensuring compliance with ever-changing regulations and tax laws.
- Juggling requests and expectations of founders, investors and valuation experts.
- Updating 409A valuations on a regular basis (usually annually or in the event of a major business development or round of funding).
Three Tips to Avoid the Pitfalls of 409A Valuations
- Choose a qualified 409A valuation provider
- Be cognizant of the need to update your 409A valuations
- Engage in the 409A valuation process
1. Choose a qualified 409A valuation provider
Many of our clients use 409A valuations that are bundled with other startup services like cap table management or the filing of 83b elections. These valuations rely heavily on technology automation, which makes them quick, easy and cheap.
Growth stage companies appreciate these attributes, but a growing number of our clients are starting to choose more dedicated valuation firms that result in a bespoke 409A valuation. A separate valuation specialist can provide a more accurate, defensible valuation because they understand the industry, can apply the right valuation methodology, and will incorporate unique circumstances and facts into your company’s valuation.
Perhaps most importantly, companies that use a dedicated valuation firm can have a more in-.depth, detailed discussion with the valuation specialist. These discussions help the company get a final valuation that the founder believes is appropriate and supportable.
2. Be cognizant of the need to update your 409A valuations
409A valuations are not one and done. Startup and growth stage companies must refresh these valuations annually, or earlier if there is a material event that potentially changes the valuation of the company.
Usually, this material change is a funding round, but it can be a number of other things. It could be a loss of a key person or a change in strategy. It could even be taking on some bridge financing on some venture debt that changes the outlook, the balance sheet and the runway facing the startup.
There are no hard and fast guidelines to determining whether an event triggers a new 409A valuation. These determinations are fact- and- circumstances dependent and may require judgment and input from the company’s experienced financial advisors and legal counsel about when that trigger point occurs.
Some attorneys take a conservative view of what constitutes a material event. For example, they might not wait for the funding to close and may consider a term sheet or even just a draft term sheet offering for a funding round as a trigger for a new valuation.
Engage in the 409A valuation process
Founders, CEOs and CFOs should remain actively engaged in the valuation process from beginning to end. This process is more than just calculating a value and preparing a report, as it includes the selection and preparation of the inputs given to the valuator, providing direction to their work, and evaluating the outcome.
To engage appropriately in the process, company management should have a general sense of the current value of the company as well as a working knowledge of the valuation process and the methodology used by the valuator, which includes understanding the assumptions and methods used to estimate future cash flow.
It helps to thoroughly prepare for the valuation rather than responding to questions and information requests as they arise during the process. At a minimum, the company should prepare the budget and cash flow projections to be used in the valuation, including documenting significant assumptions.
When reviewing the draft valuation, be sure to review all of the components that make up a 409A valuation to make sure that they accurately reflect current business conditions and have been correctly and appropriately considered in the valuation. This review should include an assessment of whether the valuation has appropriately considered the nature of the company’s IP.
Final Thoughts on How Startups & Emerging Growth Companies Can Establish 409A Valuation Success
Valuations are subjective and result in a range of acceptable values, not a single “right answer.” Management’s goal for their 409A valuations should be that the valuation is current and that it properly incorporates management’s best judgments and assumptions about future events.
The result should be a valuation that is supportable to third parties and which the company’s management team can communicate and explain with confidence.