09/21/2021 | News release | Distributed by Public on 09/21/2021 13:12

How to evaluate your 409a valuation

One recurring cost for your startup is your 409a valuation, which determines the strike price for your stock options. It's important to get it right since it impacts the returns your employees will see as the company grows and the equity you can offer to future hires. Let's discuss all the factors that go into determining your valuation and how you can negotiate for a lower strike price.

What is a 409A valuation?

A 409 valuation is an independent evaluation of the fair market value of a company that sets the price of stock options. Let's break down what this means:
  • Independent evaluation: The 409A analysis needs to come from a third-party auditor who has nothing to gain from the valuation results.
  • Fair market value (FMV): This is the price your business is worth in an open and competitive market. For public companies trading in the stock market, the FMV is the company's market cap. For private companies, the FMV is typically based on your company's valuation at the last financing round but will be reduced because of the increased rights given to investors and because you can't trade your company's stock.
  • Price of stock options: Startup employees receive equity in the form of stock options. Options give employees the right to purchase shares at a discounted price relative to what investors pay. The price you pay for options is the strike price.
Determining the strike price of options is the heart of the 409A valuation. A low strike price from the 409A valuation allows employees to buy shares at a discount and benefit as the company grows and the share price increases.

Benchmarks for 409A valuations

A common misunderstanding on 409A valuations is that the goal is to have as low of a strike price as possible. The goal is not to get a low strike price. The goal is to get the lowest defensible strike price that stands up to auditors and the IRS.

The biggest drivers of your 409A valuation are:

  • Investments: Your latest funding round and the price investors paid will often be a large driver, particularly before you have revenue. The higher your fundraising valuation, the higher your 409A valuation.
  • Industry: Fast growth industries will lead to higher 409A valuations. Fintech, Biotech, and AI will demand much higher valuations because companies in those industries have a high potential for future growth.
  • Projections: 409A valuations are intended to last for 12 months, so your valuation firm includes forward-looking information such as your financial projections or goals for the business in the next 12 months. The greater your projections, the greater your 409A valuation. Of these three, your projections are the only thing within your control.

Your company's FMV is also used to arrive at its strike price and is highly dependent on your company's revenue, growth, and industry. Here are rough benchmarks we've seen based on hundreds of startup 409A valuations:

  • If you've closed simple agreements for future equity or convertible notes, your FMV will be 50-80% of your valuation. Ex: If you've raised on a valuation cap of $20 million, your valuation can be as low as $4 million.
  • If you've closed Series A-B, your FMV will be 20-50% of your pre-money valuation. If you raised on a pre-money valuation of $500 million, expect a valuation as low as $250 million.
  • Later stage 409A valuations are highly company-specific. If you've raised Series C+, 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 company.

There can be severe financial consequences for your employees if the IRS determines that your valuation is too low. If the IRS determines your 409A valuation does not accurately reflect the fair market value of your company, all of the shares you granted to employees at that value would be included as part of their gross income. The IRS can also levy up to a 20% penalty on stock options on top of the back tax.

Preparing for a 409A

The first step in starting a 409A valuation is choosing a provider. Evaluate valuation firms using these three criteria:

  1. Track record: Ask your valuation firm if their valuations have stood up against the big four auditing firms, the IRS, and SEC. Pick a valuation firm with a good record of audit-proof valuations.
  2. Domain expertise: Pick a valuation firm that has experience valuing your industry. For example, if you are a high-growth startup, don't pick an auditor who is used to valuing profitable small businesses. The valuation will take longer and is less likely to be accurate.
  3. Guarantee: Ensure that your valuation firm offers all companies free lifetime audit review support at no additional cost.

Most valuation firms ask for the following documents to determine your company's FMV:

  • Updated cap table: Inaccuracies on the cap table will affect and perhaps 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've raised an equity round, your lawyers will have "amended" this document, so make sure you have the latest on hand.
  • Historical and projected financials: This 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 projects are only an estimate.
  • Board presentation and recent pitch deck: 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: Optional, but recommended, so that the valuation firm can better understand how your cap table may evolve over the next year. The easiest way to estimate is to take your hiring plan and multiply the median number of options by the number of people you plan to hire.

Typically valuations cost $1000-$1500 for seed stage companies and increase by $500-1000 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. This comes with two risks:

  1. High valuations: Low-cost providers reduce compliance risk by over-pricing shares by almost 30-50%. The money you're saving will come out of your employee's paychecks.
  2. Deterring investors: 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.

Evaluating your 409A valuation

Anyone telling you that your 409A valuation should always be X% of your preferred share price is giving inaccurate, and potentially harmful advice. Startups can no longer just use a rule of thumb to set common stock FMV at 10-20% of the most recent preferred round. The ratio of common to preferred depends on a multitude of factors: economic conditions at the time of the fundraising and valuation, company growth, and more.

There are cases where valuations are genuinely too high due to mistaken assumptions. 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 makes it riskier?
  • Are the comparable companies and competitors accurate? Find better comparable companies that your valuation firm can use to arrive at a more acceptable enterprise value.
  • Is there any new information about the business or market that the valuation firm didn't appreciate? Is there a new competitor that just launched a product, a new innovation in your space that challenges your success?

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

Ramp can help you save on your 409a valuation

If you use Ramp's corporate card and finance automation platform, you can save on the cost of your 409a valuations by using cap table platform Pulley. We've partnered with Pulley to offer you 25% off your first year with them. Pulley works with trusted experts in 409A valuations to get you a fast, fair, and accurate 409A valuation. Their partners have 100% audit-proof defensibility against the IRS and the big four firms. They provide a lifetime guarantee on all of their reports.