How to evaluate your 409A valuation

If your startup offers stock options, a 409A valuation is one cost you’ll need to budget for. This independent appraisal determines the fair market value (FMV) of your common stock, which informs the strike price for your stock options. It’s important to get an accurate valuation, as it affects both your employees’ returns as the company grows and the equity you can offer new hires.

We discuss the factors that go into determining your 409A valuation, how it’s calculated, and how to make sure you get a fair, defensible result.

What is a 409A valuation?

A 409A valuation is a formal process that determines the value of your company’s common stock. While the outcome sets the strike price for stock options, the process itself involves assessing your startup’s financials, industry outlook, and recent fundraising.

This valuation must be completed by an independent third party, and it’s not just a one-time task; it’s a recurring expense that most startups will need to revisit annually or after a new funding round.

How long is a 409A valuation good for?

A 409A valuation is valid for up to 12 months from the issue date of the final report or until a material event occurs, whichever comes first. A material event is a business milestone that can impact your startup’s value, like closing a funding round, preparing for an initial public offering (IPO), or undergoing an acquisition.

Is a 409A valuation mandatory?

If you offer equity or plan to offer it to employees or as an IPO, then you likely need a 409A valuation. If you do not get a 409A valuation, you could undervalue stock options and incur significant tax penalties down the road.

You typically need a 409A valuation before issuing stock, especially if you’re hiring employees or bringing on advisors. A new valuation is also required after certain material events. To make sure your startup stays compliant and avoids unnecessary risk, consult legal counsel when determining whether you need a 409A valuation.

What is the penalty for not providing a 409A valuation?

If your startup needs a 409A valuation and fails to obtain one, non-compliance penalties can be severe. For example, if the Internal Revenue Service (IRS) determines your stock options are at an undervalued strike price, it can impose a 20% tax penalty on deferred amounts, which can affect the value of the company.

How is a 409A valuation determined?

The three biggest drivers of your 409A valuation include:

1. Investments: Your latest funding round and the price investors pay will often be a large driver, particularly before you have revenue. The higher your startup valuation, the higher your 409A valuation.
2. Industry: Fast-growth industries will lead to higher 409A valuations. Fintech, Biotech, and AI demand higher valuations because companies in those industries have a high potential for future growth.
3. Projections: 409A valuations last for 12 months, so your valuation firm will include forward-looking information such as your financial projections, cash flow, and goals for the business over the next 12 months. The better your projections, the greater your 409A valuation. Of these three, your projections are the only metric within your control.

409A valuation benchmarks by funding stage

Your startup’s FMV directly impacts its strike price and is highly dependent on your company's revenue, growth, and industry. Here are rough benchmarks we see based on hundreds of startup 409A valuations:

• Seed-stage funding: If you close simple agreements for future equity or convertible notes, your FMV will be 20%–50% of your valuation. For example, if you raise on a valuation cap of $20 million, your valuation can be as low as $4 million.
• Series A–B: Your FMV will be 50%–80% of your pre-money valuation. If you raise on a pre-money valuation of $500 million, expect a valuation as low as $250 million.
• Series C and beyond: Later-stage 409A valuations are highly specific to the company at hand. Expect a lower discount than your earlier rounds. At this stage, your auditor should be involved and can advise on expectations based on their understanding of your startup.

Similar to the consequences of not obtaining a 409A valuation, there can be severe tax penalties if the IRS determines your valuation is too low and does not accurately reflect your startup’s fair market value. The IRS may treat all employee shares at an undervalued strike price as part of your employees’ gross income. The IRS can also impose a 20% penalty on stock options, in addition to back taxes.

How to get a 409A valuation for your startup

1. Choose a 409A valuation provider

The first step in securing a 409A valuation for your startup is to choose a qualified service provider. Evaluate audit firms using these three criteria:

• Track record: Ask firms if their valuation services stand up against the “Big Four” auditing firms (Deloitte, EY, KPMG, and PwC), the IRS, and the Securities and Exchange Commission (SEC). Consider valuation firms with good records of audit-proof valuations.
• Domain expertise: A reputable valuation firm has experience valuing your industry. For example, if you’re a high-growth startup, don't pick an auditor that’s values profitable small businesses. The valuation will take longer and is less likely to be accurate.
• Guarantee: Ensure your valuation firm offers all companies free lifetime audit review support at no additional cost

2. Prepare your documents

Most valuation firms ask for documentation to determine your company's FMV. Here’s what you need for a 409A valuation:

• Updated cap table: Inaccuracies on the cap table can affect and delay your valuation if not caught quickly enough
• Latest articles of incorporation: This document is sometimes called a charter or certificate of incorporation. If you raise an equity round, your lawyers will have "amend" this document, so make sure you have the latest version on hand.
• Historical and projected financial statements: These can be your profit and loss statement or balance sheet from your accountant or accounting software. You need to provide financials for the past three years and projections for the next 12 months. Give your best estimate on projects for the next 12 months; valuators know that startups are volatile, and these projections are just estimates.
• Board presentation and recent pitch deck: This is optional but recommended. These materials give the valuation firm a better grasp of your business and value proposition.
• Number of options you plan to issue in the next 12 months: While not required, providing this information can help the valuation firm better understand how your cap table may evolve over the next year. Take your hiring plan and multiply the median number of options by the number of people you plan to hire.

3. Review and finalize your 409A valuation

Once you submit your documents and optional materials, the valuation firm will analyze your startup and provide a report that includes your FMV and strike price. To finalize this valuation, you’ll typically review the draft report to ensure all data is correct, flag any inaccuracies, and send it back to the valuation firm. Once everything is up to par, the firm will send a final, signed report that is valid for 12 months (or until a new material event occurs).

If your valuation provider offers lifetime audit support, keep their contact information handy in case the valuation is challenged by auditors or the IRS.

How much does a 409A valuation cost?

409A valuations typically cost between $1,000 and $1,500 for seed-stage companies and increase by $500 to 1,000 with each subsequent round. Be wary of low-cost valuation firms. Some 409A valuation firms use automated statistical models to provide fast, low-cost reports, and this comes with two risks:

1. High valuations: Low-cost valuation providers reduce compliance risk by over-pricing shares by almost 30–50%. The money you're saving will come out of your employees’ paychecks.
2. Deterring investors: IRC 409A compliance is part of the due diligence for every investor and acquirer. A missing or non-compliant report can delay or deter future investors.

Tips for reading your 409A valuation report

It’s a common misconception that your 409A valuation should always be a fixed percentage of your preferred stock price. While this may have been a simpler approach for early-stage companies in the past, it’s no longer a reliable method for determining your company’s FMV.

The ratio of common to preferred shares depends on several factors, including economic conditions during fundraising, valuation, the company's growth, and market trends.

There are cases where valuations are genuinely too high due to mistaken assumptions or flawed valuation methodology. Start by reading your report and consider the following:

• Are the company narrative and risk profile accurate? Are there long-term concerns about the company that make it riskier?
• Are the comparable companies and competitors accurate? Find better comparable companies your valuation firm can use to arrive at a more acceptable enterprise value.
• Is there any new information about the business or market the valuation firm didn't appreciate? Is there a new competitor that just launched a product or innovation in your space that challenges your success?

Treat your valuation firm as a partner in the 409A process. Valuation firms often have a point at which they believe they cannot go lower. In other words, they can’t give a valuation that's too low to defend to the IRS.

Save on your 409A valuation with Ramp and Pulley

Ramp partners with Pulley to help you save on the cost of your 409A valuations. If you use the Ramp Business Card or other products under our finance automation platform, you can get 25% off your first year with Pulley, including its 409 valuation services.

Pulley works with trusted experts in 409A valuations to get you a fast, fair, and accurate 409A valuation. Its partners have 100% audit-proof defensibility against the IRS and the Big Four firms, and Pulley provides a lifetime guarantee on all of its reports.

The information provided in this article does not constitute legal or financial advice and is for general informational purposes only. Please contact an attorney or financial advisor to obtain advice with respect to the content of this article.

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FAQs

How long does a 409A valuation take?

Once you submit the required documentation, it may take a few weeks to a month for a valuation firm to deliver a 409A valuation. The timeline can vary based on your startup’s complexity, the completeness of your business documentation, the responsiveness of the valuation firm you choose, and other factors.

What is the difference between a 409A valuation and FMV?

A 409A valuation is a specific assessment of a company’s FMV for the purpose of setting stock option strike prices in compliance with IRS regulations. FMV refers to the overall value of a company’s assets or equity, while a 409A valuation ensures the company cacluates it accurately to meet legal and tax requirements.

What is a 409A safe harbor?

A 409A safe harbor means the IRS considers your 409A valuation reasonable if it’s done by an independent appraiser within 12 months of granting stock options. This provides a layer of protection against IRS challenges unless the valuation is proven to be grossly unreasonable.