Receiving a 409A valuation is an essential step toward scaling your startup and reaching your business goals, as it allows you to issue stock options to your employees. However, many founders have questions about the process and wonder how valuations might impact their business.
Read on to learn the answers to some of your most pressing questions, including why 409A valuations are important for startups, when businesses need to update their valuations and how First Republic can support your valuation request.
What is a 409A valuation?
A 409A is a formal report that tells you the valuation — the fair market value (FMV) — of a startup’s common stock. While one can easily tell the stock price of a publicly traded company, you need an independent appraiser to determine the value of a private company.
409A valuations are particularly important for startups, as they are required to be able to issue stock options. Startups typically don’t have the budget of larger, established companies to offer competitive cash compensation, and instead rely on stock options to attract top talent. Getting a 409A allows you to issue stock options that will help you build a motivated team that's ready to help your startup grow.
Do startups need a 409A valuation?
Yes, all startups — including life science and healthcare companies — require a 409A. If you plan to issue common stock options or other equity, your business will need a 409A valuation.
When giving stock options to your employees or consultants, you are giving them the option to buy equity in your company in the future at a price (the “strike price” or “exercise price”) that is determined today. The 409A offers an appraisal that helps determine what that strike price should be to avoid tax fines later. Getting a 409A valuation through an acceptable appraiser also grants your valuation safe harbor status, which confers protection in case of an audit later.
Most startups will receive several 409A valuations over their lifespan, annually or whenever a material change in the business significantly impacts its value. Additionally, later-stage startups nearing a liquidity event — such as an IPO — will require more frequent 409A valuations, done quarterly or even monthly.
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 also need to update their 409A valuation annually, and should get a new valuation anytime there is a material change that impacts the value of the business.
Annual 409A valuation updates
Safe harbor disclosures within 409A guidance call for a 409A valuation update each year. If little has changed in the business — for example, the startup's financial and business direction have remained relatively consistent year over year — this may be the only valuation update required.
409A valuation updates after material events
If there has been a significant change in your business, you may need to get a new valuation. Several circumstances may trigger the need for a new 409A valuation, including:
A new round of funding: This is the most common change that triggers a new 409A. Bringing new institutional investors on board 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 can signal a significant reduction in risk — and an increase in the startup’s value. Conversely, missing a milestone or shifting to a new business model may impact the startup’s value and require a new valuation.
Before an initial public offering (IPO): Exploring an IPO means the startup will be required to utilize certain valuation models, and a new 409A valuation may be needed.
After several rounds of funding: Round after round of funding can eventually result in capitalization tables that are complex or difficult to understand, so startups may update their 409A valuation to reduce complexity.
These events represent some of the most common reasons to get a 409A — but this list is not exhaustive, and there may be specialized situations where your startup requires a 409A. It’s always best to consult a professional to determine when to get a 409A valuation.
Penalties for non-compliance
A 409A valuation is required by law in order to issue stock options, and a 409A violation — for example, issuing options priced lower than your company’s FMV — comes with severe penalties for employees, even if their options have expired.
The balance of the deferred compensation plan — for the current year and any prior years — will instead be taxed as income, greatly increasing employees’ tax obligations. Employees must also pay a 20% excise tax, as well as any interest that accumulated on the total balance due. In addition, they may have to pay state-level penalties, which could include a further 20% penalty tax.
How can you get a 409A valuation?
A 409A valuation should be performed by an independent appraiser who can ensure your 409A is eligible for safe harbor status.
The appraiser will select one of three methodologies to estimate the FMV of your startup:
Market approach: This method is most suited to early-stage startups who have yet to generate profit and for whom it’s difficult to predict long-term financial performance. It estimates the value of the company through comparisons to similar, publicly-traded companies.;
Income approach: Uses a company’s assets and liabilities to calculate its FMV. This approach is best suited to startups already generating revenue who have a positive cash flow.
Asset approach: May be used for startups who have not yet raised money and do not generate revenue. It estimates the value of the startup’s assets to determine FMV.
Considerations for life science companies
In general, the valuation process is more complex for life science companies, which may not generate revenue for a long period of time.
Because of this lack of revenue, an income-based approach may not make sense for life science companies. Broadly, a market approach will be more appropriate for a later-stage organization with many comparable publicly traded companies. For early-stage companies, a valuation provider may take an asset approach, analyzing the value of the startup’s intellectual property, value of potential future contracts and other factors.
For life science companies, valuation providers will generally treat National Institutes of Health (NIH) grants and other grants like rounds of funding: Phase 1, Phase 2 and United States Food and Drug Administration (FDA) approval are all milestones that a company in this industry must hit, even though they are not directly tied to revenue.
A valuation provider may use the Probability-Weighted Expected Return Method (PWERM), which determines the value of equity securities based upon an analysis of possible future outcomes. This method can be especially helpful for life sciences, where the outcomes for companies tend to be binary — either a company gets a product to market or not.
In short, seek a provider with industry knowledge.
How much does a 409A cost?
The cost to procure a 409A varies depending on the provider you choose and the complexity of your business. Prices can be as little as $1,000 for an early stage company with a simple cap table but costs can increase over time as the complexity and stage of the company increases. Some providers may bundle valuation services other equity management services.
How long does it take to get a 409A?
For an early-stage company with a simple cap table, a 409A valuation may take just a few business days. This can increase to up to a few weeks for later-stage, more complex companies.
How can First Republic help?
At First Republic, we’re here to help founders at every stage of their business, including in securing a 409A. We currently work with a variety of providers, including Carta, Shareworks and Pulley to help you expedite your valuation request.
We’re also here to offer well-rounded support for your startup, from offering trusted advice that helps you set financial goals for your startup to finding customized solutions to fit your company’s unique needs. Reach out to your representative or request a call to discuss your needs; we would be happy to assist.