The internal revenue code section (IRS) 409A regulates non-qualified deferred compensation. Most of the time, the non-qualified deferred compensation are equity plans for employees.
409A valuations set the fair market value (FMV) of a share of common stock in a private company. This valuation determines the cost (exercise price) to purchase a share.
In order to issue options, your company needs to get a 409A valuation done from an independent valuation firm (often termed as qualified third-party appraisers). Getting an independent valuation firm helps companies to establish a "safe harbor" and ensure that the company follows tax laws. Safe Harbor guarantees that the IRS must accept the valuation unless they can demonstrate that the valuation is too "unreasonable."
Specifics: How are early-stage companies valued?
It can be really frustrating for a founder when it comes to valuing your early-stage company. There’s no general rule of thumb to value a company, financial consultants and appraisers have different ways through which they assign value to the company and those are often subject to the best understanding of the company as of the Valuation Date.
Valuing an early-stage company is often a challenge due to
Pre-revenue / no material revenue
No outside capital / bootstrapped
Pre-product / MVP stage
No paying customers / early pilots
No historical data / only operating losses
Range of uncertain factors (market, financial, and economic risks)
A well-known methodology that is very common among appraisers to value early-stage companies is called the Asset Approach. This methodology is used for very early-stage companies that are pre-revenue and have not raised an equity round. The Asset Approach is also used for companies that have raised debt instruments like Convertible Notes and SAFEs as they are often treated as debt until a priced equity round has occurred.
The approach takes into consideration the costs (personal & fixed) a third party would incur to recreate the company’s asset from inception. Personal costs include salaries to employees and contractors as per market standards and Fixed costs include overheads like rent, software, IT equipment, and others.
Other Methods
Income Approach
The income approach is based on the premise that the value of the business is the present value of the future earning capacity.
It involves estimating the discounted cash flow (DCF) for the business by projecting the free cash flows each year, calculating a terminal value, and then discounting these cash flows to a present value at an appropriate discount rate. The greater the risk associated with the forecasted cash flows, the higher the discount rate applied to them, and the lower their present value.
Although it is difficult to forecast more than a few years into the future with any accuracy, especially for an early stage business without meaningful revenue, this process may result in the most appropriate indication of value for a company with significant projected growth.
Market Approach
The market approach is based on the premise that a business can be valued by comparing it to other companies which are being acquired or which are publicly traded.
It involves estimating the value of a business by looking at actual transactions in the equity of similar companies, whether the transactions are trading in the shares of such companies or the acquisition of such companies. Another limitation arises if the company being valued has no earnings or has immaterial revenue, mostly the case with early-stage companies.
The other generally accepted approaches to Valuations are:
Types of techniques under the Market Approach:
Guideline Public Comparables - This technique involves searching for publicly traded companies similar to the company being valued. Multiples of revenue and EBITDA are calculated for these companies and then applied to the company being valued. This approach generally works for companies that are mature and are projecting stagnant growth for the next couple of years.
Guideline M&A Transactions - This involves searching for recent merger and acquisition (M&A) transactions involving companies similar to the business being valued. Multiples of EBITDA and revenue are calculated for these transactions and then applied to the business being valued. It can be difficult to find M&A transactions involving companies that are truly comparable and another issue is that the company is valued as well as the companies which have been acquired, may not have a meaningful amount of revenue and EBITDA.
Prior Sales of Common Stock - This method involves examining any transactions involving the stock of the business being valued. Such transactions can be very helpful in directly establishing the value of the business. However, such transactions are rare, and when they occur, they do not provide meaningful valuation information because there were small transactions spread over too much time, the transaction did not involve the same class of stock, the transaction was arranged under duress, or the transaction was for a large block rather than a minority interest.
How long is my 409A valuation valid for? Do I need one regularly?
409A valuations are valid for a maximum of 12 months after the effective date or until a “material event” occurs. A material event could affect a company’s stock price. After those 12 months or material event, a new valuation is needed.
For the majority of early-stage startups, a qualified financing is the most commonly encountered material event. A qualified financing typically includes a sale of common shares, preferred equity, or convertible debt to independent, institutional investors at a negotiated price.
For later stage companies, an employee options buyback or a secondary could also be considered as a material event.
Do I really need to get a 409A report for my early-stage company?
If you are planning to issue options to employees, you most likely need a 409A valuation.
While there are some workarounds for early-stage companies, getting a 409A valuation is the surest way to set your company up for success down the road. When a company grows and goes through a due diligence process, the audit firm may not be able to issue the audit if there is no formal documentation on the early-stage valuation.
🧮 Getting a New Valuation
How can I request a 409A valuation?
Getting started is simple, just give us some information about your company. On your AngelList Stack company dashboard, go to the New Valuation section under "Financial Services", then go through the form.
FMV Request Form
Once you submit all of the information, you will be connected with our third-party provider who will reach out to discuss timelines and any additional information necessary.
How long does it take to get a 409A valuation?
As soon as you request a 409A valuation through the platform, you'll be connected to our valuation partners. The exact timeline depends on the complexity of your cap table, but you should have your valuation back within three to four business days.
Typical data collection involves cap table details, options ledger, historic and projected financial statements, public comparables, potential liquidity timeline, and other qualitative information about your company’s performance over the last 12 months.
Should I get a 409A valuation if my company is in the middle of fundraising?
If you're in the middle of a raise, it makes the most sense to wait until after the raise to get the new valuation. If you need to grant options before closing the raise, you can promise options as needed and they would have the strike price of the future 409A valuation.
How much will the valuation cost?
Stack's Starter and Growth Plans include 409A valuations. You can view pricing here.
📡 Tracking Valuation
How can I upload a completed valuation for tracking?
