How to Do a 409a Valuation for Your Company

A 409A valuation is an independent appraisal determining the fair market value of a private company’s common stock. Primarily for tax purposes, it ensures compliance with Section 409A of the Internal Revenue Code, which governs non-qualified deferred compensation plans. This valuation provides a defensible price for common share grants, helping companies and employees avoid significant tax penalties.

When a 409a Valuation is Needed

A 409A valuation is typically required annually or upon specific events materially impacting a company’s value. IRS guidance requires a new valuation at least every 12 months to keep the fair market value current. Companies often align this annual valuation with their fiscal year-end or a significant operational milestone.

A new valuation becomes necessary when a “material event” occurs. Granting new stock options or equity awards, like restricted stock units, triggers an updated valuation. This ensures the strike price reflects current fair market value, preventing “in-the-money” options that could lead to immediate employee taxation and company penalties under the Section.

Significant fundraising rounds (e.g., Series A, B) are material events requiring a fresh valuation, as capital infusion and new investor terms alter financial standing and ownership. Major operational changes (e.g., new product launch, revenue shifts, acquisitions) or capital structure changes (e.g., new stock classes, debt restructuring) also necessitate an updated valuation.

Data and Information Required for Valuation

Preparing for a valuation requires gathering comprehensive documents and financial data to accurately depict the company’s health and prospects. This includes:

Historical financial statements (income, balance, cash flow) for the past three to five years, providing insights into past performance and stability.
Financial projections for the next three to five years, detailing anticipated revenue, expenses, and profitability.
A detailed capitalization table, listing all outstanding equity instruments and clarifying ownership structure.
A comprehensive company overview, including a business plan, history, organizational chart, and management team biographies.
Analysis of the competitive landscape and industry trends.
Operational data, such as customer acquisition costs, customer lifetime value, and the product roadmap.
Details on intellectual property (patents, trademarks) and significant contracts or partnerships.
Information on prior valuations and funding rounds, including terms and investor names.
Legal documents, such as Articles of Incorporation, bylaws, shareholder agreements, stock option plans, and debt agreements.

Key Valuation Methodologies

Independent valuation firms use a combination of methodologies to determine a company’s fair market value, tailored to its stage and industry.

Asset Approach

The asset approach is relevant for asset-heavy companies or those undergoing liquidation. This method focuses on the fair market value of the company’s tangible and intangible assets, minus its liabilities.

Market Approach

The market approach uses data from comparable companies or transactions. The Guideline Public Company Method (GPCM) analyzes financial performance and valuation multiples of similar publicly traded companies, adjusting for differences. The Guideline Transaction Method (GTM) uses data from recent mergers and acquisitions of comparable private companies. The Prior Transaction Method (PTM) leverages the company’s own historical financing rounds, requiring adjustments if significant time or material events have occurred.

Income Approach

The income approach, particularly the Discounted Cash Flow (DCF) Method, projects future free cash flows over five to ten years. These are discounted to present value using a rate reflecting risk, and a terminal value is calculated. After determining overall company value, additional models allocate value across share classes.

The Option Pricing Model (OPM) treats each stock class as a call option based on liquidation preferences. The Probability Weighted Expected Return Method (PWERM) assigns probabilities to future liquidity scenarios (e.g., IPO, acquisition) to calculate and weight the value of each share class.

Steps in the Valuation Process

The process of obtaining a valuation involves several steps:

Selecting a qualified and independent valuation firm with industry experience.
Submitting data, including financials, projections, and cap table details, often via secure channels, followed by a kick-off call to discuss the business and timeline.
Analysis by the valuation firm, reviewing provided information, applying methodologies, and conducting independent research to arrive at a preliminary valuation range.
A Q&A and review period, where the company addresses follow-up questions and reviews a draft report for factual accuracy.
Delivery of the final valuation report, detailing methodologies, assumptions, and the determined fair market value per share. This report serves as official documentation for compliance and must be retained for IRS audit purposes.

Citations:

409A Valuation: What it is and Why it Matters. https://www.forbes.com/advisor/business/409a-valuation/
What is a 409A Valuation? https://www.carta.com/blog/what-is-a-409a-valuation/