Stock options are an important resource for startups in their quest to attract and retain top talent. In addition to offering employees a stake in the company's future success, stock options provide a strong incentive to drive growth. Before you can grant these options, however, your company must undergo an important step: the 409A valuation.
Typically, an independent evaluator will determine your 409A valuation based on a variety of industry-standard methods. The methods that evaluators use will be different depending on the growth stage of your company. It’s important to understand which methods are most applicable to your 409A valuation during the Pre-Seed and Seed rounds, and what you can expect down the line as your startup matures.
Here’s a quick refresher: a 409A valuation determines the fair market value (FMV) of your company’s common stock. It’s required for compliance with regulations from the Internal Revenue Service. It also sets the strike price for the stock options offered to employees.
As a business partner manager at Fidelity Private Shares, I spend a lot of time speaking with founders of venture-backed companies. There tends to be some general confusion around the topic of 409A valuations amongst startup founders and operators.
If you’re looking for a deeper dive into 409A best practices, check out Fidelity Private Shares’ free 409A guide for private companies. You can also learn more about how we help companies conduct faster, accurate, and competitively priced 409A valuations.
Let’s discuss some key 409A considerations based on company stage, so you can know what to expect as you enter the valuation process:
Early-stage 409A methodology (Pre-Seed to Seed)
Many early-stage companies lack a significant financial history. At the earliest stages, some companies may not have even generated any revenue.
For example: a biotech company developing a new medical device might only be able to rely on its initial research and testing if it hasn’t successfully brought that device to market.
In general, early-stage valuations are determined with less concrete data points. However, there are some common factors that tend to apply to early-stage company valuations:
Comparable companies
This market-based approach involves evaluating comparable companies to estimate the growth potential of your business. Evaluators will typically examine similar companies within your industry, looking at the investment deals they’ve secured or the cost of acquisition if they’ve been acquired.
Cost to Duplicate Method
Evaluators might also use the cost to duplicate method. Using this method evaluators would estimate what it would cost to build a similar company to determine the valuation. In the case of a software business, the “cost to duplicate” that company would factor in research and development, patents, and prototype development.
Independent evaluators may also base their valuation on additional factors such as:
- Company History: How long has the company been around? Have they produced revenue, or shown signs of predictable growth?
- Founder Background: Have the founders previously started a company? What qualifications do they have to lead the company?
- Previous Investment: Who is listed on the cap table? Have outside investors already backed the company?
Overall, it’s important to understand that in the early stages, evaluators will examine both the existing infrastructure of the company and market-based factors.
What is safe harbor status?
This is a term that founders might encounter as they start the process of understanding 409A valuation methodologies.
409A safe harbor is an IRS designation that can be claimed as a result of a 409A valuation. Safe harbor status is granted after a valuation is completed and it meets certain criteria set forth by the IRS. Once granted, if the IRS calls your valuation into question, the burden of proof will fall on them to prove that the valuation is unreasonable. This status can mitigate the risk of IRS auditing or future tax penalties.
The conditions set by the IRS for safe harbor status on your 409A valuation are:
- An independent appraiser with no vested interest in the business completes the valuation.
- That independent appraiser is a qualified individual with significant experience or qualifications to make the valuation.
- The valuation is done no more than 12 months before a relevant transaction.
- There must be a written valuation report documenting the process and methodology used to provide the valuation.
Later-stage 409A methodology (Series A or later)
When evaluators are completing their valuation for businesses in later stages, they’ve got more financial history to work with. Later-stage companies have already taken on funding, and there are likely more established comparables in the market.
Comparables and cost to duplicate could still factor into a later-stage valuation. However, there are a few additional common methods used to generate 409A valuations for later-stage companies:
Backsolve method
The backsolve method is typically the most used method for later-stage companies. It helps to establish a value for common stock based on the company’s most recent fundraising event. The remaining stock left for common shareholders is discounted for its lack of marketability – which means it cannot be easily sold – to help determine the 409A valuation.
Discounted cash flow (DCF) method
Discounted cash flow is a valuation method that uses a company’s expected future cash flows to estimate the value of the company. Once you’ve got a financial history and cash flow on the books, it’s easier for evaluators to leverage that and use it to analyze forward-looking projections.
PWERM
Evaluators might also use the probability-weighted expected return method, or PWERM, to determine the 409A valuation for later-stage startups. This method is a multi-step scenario-based method that uses the probability-weighted present values of potential future outcomes. This method provides valuations for exit scenarios like going public, getting acquired, or even a change in plans resulting in no exit, to offer insight into various future paths.
Fidelity Private Shares: 409A valuations for every stage of the startup journey
409A valuation methodologies can vary for early-stage or later-stage startups, mostly due to the availability of information and other qualitative factors.
For early-stage startups, there’s limited quantitative data, very specific valuation methods to be used, and the market dictates what the evaluators might determine a bit more. There may be more emphasis on the founder(s), the length of business history, and the current equity and debt.
Clean cap tables and company data rooms will allow companies to quickly deliver the necessary documentation to evaluators. An all-in-one equity management solution like Fidelity Private Shares is a great option for founders looking for a way to stay organized.
If you’re feeling overwhelmed or simply want to learn more about 409A valuations, check out Fidelity Private Shares’ free 409A guide for founders and operators.
Additionally, if you need a trusted, independent 409A valuation, learn more about our 409A valuation services.
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