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The 409A valuation process your provider follows could be the difference between compliance and penalization from the IRS.

Those penalties won’t just be yours to bear. If your stock options are undervalued, your employees could face a 20% penalty tax in addition to paying back taxes—that defeats the purpose of offering them stock in the first place.

Familiarizing yourself with what a proper 409A process looks like is well worth the time. It’ll help set expectations and give you confidence your 409A valuation provider can deliver an audit-defensible valuation.

In this article:

– I’ll walk you through our 409A valuation process.

– You’ll learn the process, the time it takes, and the methodologies used.

The 409A Valuation Process – 6 Steps

Your partner should follow similar processes to those I’m explaining below (we’ve completed over 3000 valuations and have always passed IRS audits).

Your starting point is choosing the right 409A valuation consultants to help you.

Day 1: You’ll then do an initial call and share the proper documentation and information with us.

Day 2-8: We then conduct initial modeling and analysis aligned with IRS rules and your goals, followed by an in-depth review and report creation.

Day 8-10: We send you a draft report, then incorporate feedback and the changes needed.

Our 409A valuation services take no longer than 10 days but can be completed in as little as 1 day if needed (fast turnaround times increase 409A valuation costs).

Let’s look at those steps in more detail:

Step #1: Initiate the 409A Valuation Process – Choose Your Provider

Time taken: You can vet and choose a provider in as little as 1-2 days.

If it’s your first time needing a 409A, or if you’re unhappy with who you used before, then you need to find your valuation partner.

As you make that choice, keep these 3 tips in mind:

– Look for experience and pedigree: Find out who the analysts are, how many years they’ve worked in valuation, what methodologies and processes they follow, and where they’ve worked before.

– Check their turnaround time: An efficient provider shouldn’t take longer than 10 days to deliver a 409A valuation.

– Prioritize real human customer service over automation: Your valuation team should be led by human expertise and be able to answer questions and consult with you on your start-up journey.

Your 409A partner will determine the rest of the 409A valuation process you follow.

It’s also important to remember that the process I’m outlining is specific to Eton. Other firms will have variations from ours.

Step #2: Prepare for Information Collection

Time taken: 1-2 days (client side)

Once you’ve signed on with a 409A valuation firm they’ll let you know what documentation is needed to get started.

If you don’t have the documents prepared then you should expect some delays. This is often the case and is where I see the most bottlenecks.

Hopefully, by knowing what you need, you can prepare the information in advance thus expediting, not hindering, your time to completion.

At Eton, we request:

– financial statements (if you have them)

– financial forecasts (if you have them)

– capitalization table

– articles of incorporation

– bylaws

– stock option agreement

– the deck you show investors

– SAFE notes (if you have them)

– convertible debt (if you have it)

– straight debt (if you have it)

Upon receipt of these documents, our side of the process starts. The first thing we’ll do is check we have everything we need. If we don’t we’ll get in touch immediately and make additional requests.

But from here on out your input and effort are minimal. That way you can get back to the work you enjoy doing, which pushes your business closer to that next stage of growth.

Step #3: Tailored Consultation – Choosing Your 409A Valuation Date

Time taken: 1 day (client and valuation firm)

We make the time for every client to have a call and discuss what their needs are for this valuation. But not every client desires or has time for a call, so we can also conduct this asynchronously.

Either way, we’re on hand to help. It’s part of our service to understand what prompted your 409A valuation and what stage you’re at as a start-up. These details will inform the methodologies we choose and determine if we need to fast-track the process to meet deadlines.

We’ll ask you at this point to choose a valuation date. The valuation date is the date on which the fair market value of your company’s stock will be determined.

And if you’re not sure what date to choose, we’ll make some suggestions to assist with this choice (alongside the advice of your regular corporate securities counsel).

There are a few things we’ll take into consideration when choosing the date, such as if you’re approaching or have just passed a major corporate event, you’re close to the end of the fiscal year, and when you want to issue stock options to employees.

Your 409A is valid for a year from the date of valuation or until a ‘material event’. Material events include financing rounds, terms sheets for financing rounds and acquisitions.

Step #4: Valuation & Modeling in the 409A Valuation Process

Time taken: Anywhere from 1-7 days (depending on specified turnaround time)

Once we have your valuation date and we’ve received your documents, the real work begins.

And part of that work involves considering and applying valuation methodologies.

409A Valuation Methodology: What’s Used in a Valuation?

There are three 409A valuation methodologies we use:

1. market approach
2. income approach
3. asset approach

Each one adheres to the AICP (American Institute of Certified Planners) published guidance on 409A valuations.

Which one gets applied depends on the developmental stage of your business. For example, a Series A 409A valuation might use a different methodology than a seed-stage valuation.

Generally speaking, early-stage start-ups that have raised funding but aren’t yet profitable will rely on the market approach. Those who haven’t generated revenue and who haven’t raised funds will likely use an asset approach. In both instances, because of the early stage, the company is unable to reliably forecast financials.

The income approach is often applied to businesses that are bringing in revenue with a positive cash flow. They will be able to forecast financials.

We always look to see if one (or all three) approaches fit your situation and will continue to consider them as options throughout the valuation process.

What Do You Focus on Most When Calculating a 409A Valuation?

The biggest focus is on your stage of development, cap table, and existing financials.

We’ll also look at:

– industry trends and market conditions

– recent financing (and who invested and at what valuation)

– stock option and equity grant practices

– intellectual property and intangible assets

– potential risk factors

Each 409A valuation is unique, and the emphasis on these factors can vary depending on the specific circumstances and characteristics of the company being valued. Your company might have considerations that another wouldn’t.

What Key Risk Factors Do You Look For in a Particular Company?

Risk factors can significantly impact the fair market value of a company’s common stock.

Here’s what we look for in every valuation we do:

– Market risk: This includes the volatility and dynamics of the market the company operates.

– Financial risk: This involves analyzing the company’s financial health, including revenue, profitability, cash flow, and capital structure. High levels of debt, inconsistent revenue streams, or poor cash management can increase financial risk.

– Operational risk: This refers to risks associated with the company’s day-to-day operations. It includes the efficiency of production processes, supply chain management, human resources, and the ability to scale operations.

– Regulatory and compliance risk: For companies in highly regulated industries (like healthcare, financial services, or energy), compliance with government regulations and the potential for regulatory changes are significant risk factors.

– Technology and product risk: This is especially relevant for tech companies and startups. It includes the risk associated with the development of new products or technologies, the potential for obsolescence, and intellectual property risks.

– Management and key personnel risk: The experience, skill, and stability of the management team and key personnel are important to the valuation. High turnover, lack of depth in the management team, or reliance on a few key individuals can be risk factors.

– Customer concentration risk: Dependence on a limited number of customers for a significant portion of revenue increases risk. Losing one or two major customers could have a substantial impact on the company’s financials.

– Industry-specific risks: Each industry has its unique set of risks. For example, biotech firms face risks related to clinical trial outcomes, while tech companies might face rapid technological changes.

– Legal and litigation risk: Ongoing or potential legal issues, whether related to intellectual property, labor laws, or other legal disputes, can pose significant risks.

– Economic and political risk: Broader economic conditions, interest rates, inflation, and political stability can impact a company’s performance, especially for those with international operations.

– Liquidity and exit strategy risks: The likelihood and timing of a liquidity event (like an IPO or acquisition) can be uncertain, impacting the valuation. The absence of a clear exit strategy can be a risk factor.

– Competitive risk: The level of competition in the industry and the company’s competitive position are important. High competition or a weak competitive position can increase risk.

Early-stage companies, such as Series A or earlier, often face more uncertainty and risk than established businesses that have proven success and tangible data to pull from.

Step #5: Receive a Completed Draft Report

Delivered on: day 7 (by valuation expert)

Your dedicated analyst will prepare the draft valuation calculations which include the methods chosen, assumptions made, data pulled, and the draft fair market value conclusion.

We’ll let you know when you can expect to receive this draft. That way you can reserve time in your schedule to review it.

As soon as it’s completed, we’ll send them to you.

Step #6: The Final 409A Valuation Process Stage – The Sign Off

Received on: day 10 (client to review and raise any concerns and questions)

Time taken to finalize: 1-2 days

With your draft report now in your possession, you have the opportunity to review it. Check that you understand the assumptions made and are comfortable with the valuation numbers.

If anything is unclear or you have concerns, you can schedule a call with us and we’ll discuss any issues in detail.

When you’re happy with the valuation, we’ll both sign off on the draft calculation pages.

Then you’ll authorize us to prepare the final report. That final report will be delivered to you within 1-2 days.

Final Tips – How to Make Your 409A Valuation Process Smooth

Most of the 409A valuation process is in our hands but of the few tasks you’re responsible for this is what I’d advise:

– Have your documentation ready (this can lead to delays and additional fees)

– Block out time to review the draft report (this will keep the process on schedule and prevent you from having to deprioritize other work)

– Choose a 409A consultant you can trust (they are your line of defense against IRS audits and ultimately determine your compliance)

Having completed so many 409A valuations, we’ve fine-tuned our process to be as smooth as possible for our clients.

If you want to be among them, get in touch us here at Eton Venture Services. We’ll deliver a 409A valuation that’s accurate, defensible, USPAP compliant, and aligned to your business’s desired outcomes—whatever they may be.

409A Valuation Process – Our FAQs

Here are some commonly asked questions we get about the 409A valuation process.

Should I Do a 409A Valuation by Myself?

No. 409A valuations are complex and require a deep understanding of financial modeling, tax laws, and market analysis.

You should only ever use a professional analyst from a specialist firm. This way your 409A valuation gets safe harbor status from the IRS, meaning the onus is on them to prove your valuation is inaccurate if audited.

Most companies engage external valuation experts or firms to ensure accuracy and compliance.

How Frequently Are Companies Required to Have a 409A Valuation?

Typically, companies will have a 409A valuation at least once every 12 months.

However, if there are significant events such as a new funding round, material change in the business, or substantial financial growth, a new valuation may be needed sooner to reflect these changes accurately.

Read our full guide to 409A Requirements & Compliance.

What Are the Tax Penalties or Consequences for Not Performing a 409A Valuation?

Failing to perform a 409A valuation can lead to severe tax consequences.

If the IRS deems stock options to be undervalued, employees may face immediate taxation on vested options and an additional 20% penalty tax, plus interest. The company may also face penalties for failing to withhold taxes properly.

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Company Name: ETON VENTURE SERVICES
Contact Person: Mark Henery
Email: Send Email
Country: United States
Website: https://etonvs.com/