Whether you are an investor contemplating what you should invest in or someone looking for investments, you both need to know what a 409A is to help make financial decisions. You may be wondering what a 409A is and why you need it. The simple answer is its used to determine the fair market value of your company’s stock options. If you are a private company this is a very important document so investors can make an informed decision about whether to invest or not. It is also a requirement by law that you have this. It will cause Do keep in mind that the values you see of that stock is not the common price, it is the post-money value based on the preferred price.
1. Why it was created
The IRS created the 409A because there were too many instances where startups lacked the ability to properly price their stock options. It’s required so companies price it correctly before issuing them to their employees.
2. Why it’s needed
Stock options help startups gain and retain employees. Offering this to potential employees gives them something extra to persuade them to join your team. This is important because in the beginning stages of any startup it can be difficult to convince people to take the risk to join your company.
3. What can affect the value
The value depends on the approach you take to appraise the 409A. There are a few different approaches which include the asset approach, income approach, and the market approach.
Asset: The intangible and tangible assets of the company are analyzed.
Income: The free cash flow is analyzed to determine what is to be over the next 5 years.
Market: Other companies and transactions within the marketplace are compared.
4. How and when do you need to complete this
You can complete the 409A yourself but it is risky to do it this way because there is no protection. It’s obviously the cheapest option but if you make a mistake and the IRS gets involved, you are in serious trouble. If you use a software you may face a similar problem as doing it yourself. Do keep in mind only really early startups (less than $500K in funding, revenue inconsistent, and not within 180 days to an IPO) can use the software.
The best, most secure method is to hire a company to do it for you so you can receive protection in case the IRS comes knocking. These companies know exactly what to show if it comes to this. The whole process of providing your documents to receiving the final report can take about a month. Of course, you can pay extra to get it done faster if you need to.
This is not something you fill out once and you’re done. Startups need to do this every 12 months so that their stock option prices stay correct and current. You also need to complete this every time you enter a new round of funding. Failure to do this will have serious consequences.
5. How this is related to investments
When a startup ventures out to raise capital, it trades money for shares in the company. This provides the investors with some security. This security means that if the company liquidates then the investors are first to get their money back.
Providing investors with these kinds of shares gives them a little bit of say in the company versus common shares which don’t have any say in what the company does. When it comes down to it, all the things that common shareholders don’t have, the preferred shareholders do. Also, the price difference between these 2 differs more in the beginning stages of the startup.
The 409A valuation also determines the strike price for the stocks. This is incredibly important to note because its how the compensation expense is calculated. This adds real value so if it is low then the price of the stock options is lower in cost for the company but more interesting to the stockholders. If you are looking to present this to VC’s then you should understand that they know it’s better for it to be low so keep that in mind when presenting. You will not get any funding if you do not meet the IRC 409A requirements.
6. What can deter investors
When the strike price of the stocks the investors purchase from you end up being a fraction of the investment price, your investors will get very frustrated. You need to take into consideration the potential dollar value (value the startup wants to have at IPO) of the equity you are providing. The investors’ value should be a double-digit multiple of the 409A. Imagine investing in a company with a decent value and then finding out it was overestimated. This can confuse and deter your investors causing serious problems for your company.
Risk factors investors may look at are market saturation. If there is a lot of competition then it can be riskier. However, if it is a more unique product or service then the risk has to do more with product development. They will look at the capital raised and if it is enough to get free cash flow or whether you will break even. The correlation between the market response of the product to its growth prospects is also taken into consideration by investors. If you are already established then it’s more about economics and the profitability of the company. With all that being said, there are many ways to attract investors even if there are risk factors.
7. Top tips to takeaway
a) Keep the value of your 409A low. If the market is really hot, startups/small companies may notice their 409A value is higher.
b) Less experienced investors want employee equity connected to their cost of investment.
c) More experienced investors correlate equity compensation to future returns. Future returns are more important than the beginning numbers.
d) Investor value and 409A’s are not the same things and they are not linked together. Getting investment changes the investment value but not necessarily the 409A value.
e) Increases in your 409A value does have a huge impact. If you think you need to complete a 409A valuation soon, people are more likely to join the company.
Again, remember if you are thinking that your company doesn’t need a 409A valuation, think again. You will be heavily penalized by the IRS. It’s better to do it, plus it has its upsides. Remember, this affects, your entire company and investors. It’s important for everyone to have a clear vision of the value of your options. If you have any questions or need help determining what you need to present to investors contact the team at SDI to help. Email us at firstname.lastname@example.org or call us at 408.802.2885.