Understanding 409A valuations is essential for startups looking to offer competitive equity compensation, maintain compliance and set the stage for long-term growth and success. Many founders feel uncertain about the process and want to know how setting a valuation might impact their business. Learn more about the process behind 409A valuations, including when and why they are needed.

What is a 409A valuation?

A 409A valuation is an appraisal that determines the fair market value (FMV) of a company’s common stock. It’s named after the section of the U.S. tax code that sets rules for nonqualified deferred compensation plans issued by private companies, such as stock options or restricted stock units.

409A valuations are particularly important for companies that issue stock options to employees, consultants, directors and others. They must ensure the pricing of equity-based compensation is reasonable and defensible under IRS regulations. 

Do startups need a 409A valuation?

Startups typically use equity compensation to attract top talent and narrow the compensation gap between themselves and more capitalized competitors. A 409A valuation serves as documentation that the company determined its value in a reasonable way. Getting the 409A valuation through an accredited appraiser can offer the valuation safe-harbor status, which better protects the company in the case of IRS audits.

When a company issues stock options to its employees, it gives them the option to buy equity in the company in the future at a set price, called the “strike price” or “exercise price.” The tax code compares the exercise price against the 409A valuation. If there’s a discrepancy, the IRS might impose additional restrictions or penalties.

When do you need to get a 409A valuation?

A 409A valuation is required before you offer equity—including stock options—in your company. Startups need to update their 409A valuation annually or sooner if there is a material change that may impact the value of the business. Other circumstances may trigger the need for a new 409A valuation, including:

• A new round of funding: This is the most common change that requires a new 409A. Raising from professional investors affects the value of the startup’s equity and requires a new valuation.
• Hitting (or missing) a milestone: Launching a new product or meeting another major milestone may increase a startup’s value. Conversely, missing a milestone or shifting to a new business model may negatively impact the startup’s value and require a new valuation.
• Before an IPO or M&A event: When exploring an IPO, merger or acquisition, management weighs different valuation outcomes. A new 409A valuation may be needed if a certain probability of exit is crossed.
• Changes in capitalization: Sometimes a company recapitalizes to simplify its ownership structure, which requires a new 409A valuation.

These events represent some of the most common reasons to get a 409A, but there may be unique situations that affect your company. It’s always best to consult a tax professional to determine when to get a 409A valuation.

What happens in a 409A valuation?

An independent appraiser who can ensure the 409A uses a safe-harbor method should perform the valuation. The appraiser will usually select one of three 409A valuation methodologies to estimate the FMV of a startup:

1. Market approach: For early-stage startups that have yet to generate profit and have difficulty forecasting long-term financial performance, the market approach may be the best option. The method compares the startup to similar public companies or recent M&A transactions. 
2. Income approach: This method uses a company’s assets and liabilities to calculate its FMV. It’s best suited to startups generating revenue with positive, stable cash flow. 
3. Asset approach: This method estimates the value of the startup’s net assets to determine FMV. It’s often used for startups that haven’t raised money or don’t generate revenue.

When a company has multiple classes of stock, such as common and preferred shares, determining the FMV for each class can be complex. In these cases, the option-pricing model (OPM) is often used to allocate the FMV across the various classes of stock.

The OPM factors in the particular rights and preferences associated with each class of stock. For example, preferred shareholders may have additional benefits beyond common shareholders, such as downside protection in the event of a company liquidation. The OPM helps assign an accurate value to the different rights and preferences for each class. 

In some cases, the OPM can also be used in reverse, a process known as a “backsolve.” This uses the prices from a recent funding round to calculate the overall FMV of the company, then allocating that FMV across the remaining classes.

Want to know more about managing your equity and 409A valuations? Explore J.P. Morgan Workplace Solutions, or reach out to our startup banking group for more help and guidance.