Here we wanted to give five common misconceptions about 409A valuation that we often get when talking to those involved with privately held businesses.
1. The 409A Valuation Could Impact the Next Round of Financing.
I have had countless conversations with early stage founders, particularly those going through a 409A valuation for the first time, easing their fear that a potential investor will look at the 409A valuation and use it as a way to argue that the pre-money value should be lower or that this value is what the startup is “worth” (more on this below). They worry because we do our best to come up with a defensible value at the lower end of the range. The 409A valuation should not be used for any other purpose but to grant stock options. If an investor is using this as a reference point in negotiating with you they either lack sophistication and do not understand what it is for or they are knowingly using it to justify a lower pre-money. Either way, this is a red flag. The mere fact that you have taken the responsible step of obtaining a 409A valuation should be a positive sign that you are a responsible founder who operates in a competent manner and made sure that their is less risk for you and your employees from a tax perspective.
2. The 409A Valuation Only Applies to Employees
Nope. This not only applies to employees, any time “deferred compensation” is implicated, 409A applies to everyone. That includes directors, advisers, consultants, etc…basically anyone you are making a grant to regardless of the relationship. Check with your counsel if you do have a question because this is not legal advice and I’m not a lawyer.
3. The 409A Valuation Should Come in Around 10-15% of the Most Recent Preferred Round
Try again. This was a rule of thumb made popular by venture capital investors and is no longer the case. I don’t get this comment as much as I use to, but have explained why this is not the case many times. Most people I talk to these days understand that the 409A will be more in the 25-30% of the most recent preferred round. Obviously, this is a very rough approximation for the common stock value associated with your 409A valuation but its not a bad one if you have sold preferred stock. The actual result depends on a complex array of actual investment preferences, financial factors, qualitative factors, and more.
4. A 409A Valuation Determines How Much Your Company is “Worth”
What something is worth to me personally may be very different that what it is worth to someone else. I think that there is range which makes sense but I may be willing to pay far less than another to invest in your startup. The concept of worth becomes subjective to the purchaser regardless of the asset. Further, when we value a company for the purpose of 409A valuation we are doing so with a very specific purpose in mind, tax compliance. So if you are responding to ads or companies claiming to help you “find out what your startup is worth” while selling a 409A, run the other way. They do not know what they are doing if this is how they are selling you a 409A valuation. In fact, they may either put you at risk or overprice your options. I have seen both happen and we have had the task or correcting these firms “work”.
5. 409A Does Not Apply to Partnerships or LLC Company Structures
All companies regardless of your structure are subject to 409A rules. While the firm you are working with should be making certain adjustments based on your company structure within the 409A valuation, the basic rules still apply.