What is a 409A Valuation, and why do funded startups need one?

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Hey, it's Scott Orn at Kruze Consulting, and today, I'm answering the question, "What is a 409A valuation?"

And a 409A valuation is a valuation that allows you to accurately and legally price your employee stock options. Typically, it's common stock. So back in the day when people would be working at a startup, they would get common stock options, and the board used to kinda make up whatever the price per share was. The old joke in the industry is that it would always be a penny a share, no matter how many shares outstanding and what percentage of ownership of the company, always a penny a share.

And then about 15 years ago, the IRS got smart, and they said, you know what? We think 409A valuation, or we think stock options are systematically being underpriced. And so they instituted the rules that led to 409A valuations. So basically, that means a third-party valuation provider, who's accredited, needs to actually do a couple different analyses to figure out what the fair market value of the common stock prices, and therefore what the stock option price is gonna be. And there's a couple ways to do that.

The back solve method is typically the most popular in the startup world, because the valuation provider can work backwards, hence, back solve, against the valuation that was just recently done by an independent venture capitalist who put money into the company. So typically, the back solve method yields a valuation of 25 to 35% of preferred. It can bounce around a little bit, but that's kind of the area. Another method is the cost to recreate. You can just look at that and say hey, we've built all this technology. We've got maybe all this revenue. What would it take to build this from scratch? And you have to do a pretty thorough job of listing everything out, itemizing everything, and your accountant usually gets involved.

But that's another way to do the valuation. Other ways are free cashflow analysis, or just discounted cashflow analysis, comparable multiples analysis. There's a bunch of different ways, but in the startup world, it's usually back solve or cost to recreate. But because there's all these parameters now, there's companies that do 409A valuations, Kruze, we do those with a partner, tons of them. And they're really cheap. The pricing has really come down. I think it starts at $2,000 for us. And because a lot of technology and a lot of systems have been put in place to make these scalable, and be able to a lot of 409As, the price has come down.

So it's a great time if you're needing 409A valuations, 'cause they are affordable, easy to get. It takes usually about two weeks, two business weeks, to get a 409A, but if your startup is gonna issue stock options to your employees, you're gonna need a 409A, because you don't wanna cross the IRS. And some people think oh, the IRS isn't gonna audit me, or something like that. Well, you have audit risk with the IRS, but you also have audit risk with a late-stage audit partner.

So typically, when companies hit series C or series D, they're gonna start getting audits every month, every year, excuse me, because the late-stage venture capitalists are putting a lot of money in these companies. They wanna make sure everything's audited, and really getting ready for an IPO, something like that. And if that late-stage audit firm, like a Deloitte, KPMG, E and Y, see that you didn't do 409As, or the 409As are, for whatever reason, not done properly or underpriced, they will actually throw a wrench in your audit and make you do a repricing of those options and take basically charges against your financials.

And they're doing you a favor, 'cause they're keeping you in compliance, they're keeping you clean. The last thing you wanna do is get to the doorstep of an IPO and have a lot of stock option compensation problems. So really, it's kinda like a lot of things in accounting and tax, these rules are set up to kinda protect you, in a way. But it's just best practice. Get a 409A valuation. They're good for a year, or until you have a material change in your valuation. And if you need help, just hit us up at Kruze. Hope that helps, thanks!

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