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There are two different types of valuations tied to most startups. First, there’s the value that interested investors place on the company in connection with a financing round (known as the pre-money or post-money valuation). Second, there’s the 409A valuation from an independent third party that the founder will need when granting stock options to employees.
The company’s pre/post-money valuation is negotiated between founders and investors every time the company seeks to raise a new round of financing. The 409A valuation relies on a third-party appraiser to determine the fair market value of the company.
The 409A valuation and pre/post-money valuation affect each other in a handful of important ways that VCs should understand. In this guide, we’ll break down what investors need to know about 409A valuations, including why they matter, how they’re determined, and their similarities and differences with pre/post-money valuations.
A 409A valuation is an appraisal of the fair market value (FMV) of the common stock of a private company by an independent third party. Startups typically pay for these assessments and then use the findings to inform the price at which employees can purchase shares of the company’s common stock. Common stock is the portion of a company’s stock reserved for employees and the founders.
Private companies need a 409A valuation to offer equity to employees (often a valuable recruiting tool) on a tax-free basis.
The term “409A valuation” comes from Section 409A of the U.S. tax code, which regulates non-qualified deferred compensation plans (e.g., stock options). The regulation requires private companies to specify an exercise price (i.e., the price at which employees can purchase shares of their common stock once the shares have vested) of their stock that “may never be less than the FMV of the underlying stock on the date the stock right is granted.”
A 409A valuation is needed because the value of a private company’s common stock isn’t readily available, given it's not listed on a public stock exchange.
The IRS has issued regulations that require a “reasonable method” of determining FMV at the time of grant. Using an independent third party to determine the FMV of a company’s common stock every 12 months is one way the company can ensure the value of the stock is presumed to be “reasonable” by the IRS. A reasonable valuation method establishes what the IRS calls a “safe harbor” for the company.
Without a valuation safe harbor, the company may be subject to a hefty tax penalty. A valuation deemed unreasonable by the IRS could result in all deferred compensation for all employees from the current and previous years becoming taxable immediately with an additional 20% tax penalty.
To establish a presumption of reasonableness, companies hire an independent 409A appraiser with experience evaluating companies in their industry. The typical 409A valuation cost for an early-stage company is between $1k-$5k (varies depending on the size and complexity of the company).
During the 409A valuation process, the company will typically be asked to share the following information:
For most early-stage companies, an appraiser will use a “market” 409A valuation method to determine the FMV of a company’s common stock. This means they’ll look at the financial information from a group of comparable publicly traded companies, including the stock price, revenue, and earnings before interest, taxes, depreciation, and amortization (EBITDA).
An appraiser will also consider the cost of the company’s preferred shares. These are shares given to investors that provide them certain rights and privileges to exert some measure of control over the company’s direction.
The appraiser then applies a discount to the company’s common stock to adjust for the stock’s illiquidity (which makes it less valuable than stock that can be readily sold). The discount rate varies depending on how close the company is to having a liquidity event.
A company's board must typically vote to approve the latest 409A valuation before issuing stock options.
A company must “refresh” its 409A valuation every 12 months to maintain the safe harbor. Additionally, a company will need to refresh their 409A if and when:
The 409A valuation doesn’t typically have a strong bearing on the pre/post-money valuation of a company for two reasons:
For both these reasons, the per-share price VCs pay is often higher than what it will cost for an employee to exercise their options.
On the other hand, pre/post-money valuations impact 409A valuations. An appraiser will likely increase the 409A valuation of a company if it’s coming off a large fundraise. This can indirectly affect investors by increasing the exercise price of an employee's stock options.
Additionally, how a company approaches a 409A valuation can be insightful for VCs. If the founders don’t follow the steps needed to establish a safe harbor, it can create a massive liability for the company and its employees. If the IRS comes down on the company, the tax penalties on employee options could trigger an exodus of talent.
Furthermore, poor 409A practices could potentially derail an acquisition. If a company plans to IPO, regulators, bankers, and their legal counsel will review option issuances for irregularities. If the parties find any, it could reflect negatively on the management of the company and concern potential investors.
Here are some of the key ways 409A valuations differ from pre/post-money valuations.
Founders who manage their startup on AngelList Stack get access to discounted 409A valuations (starting at $990 for early-stage companies). To learn more about Stack, visit our website.
VCs generally accept that 409A valuations are immaterial to pre/post-money valuations. But founders who aren’t vigilant about maintaining up-to-date 409A valuations may raise a red flag to investors. As such, it's important that founders manage 409A valuations diligently for the benefit of their employees and other shareholders.