Parameters to Look for in Your 409a Valuation Report

If you offer stock-based compensation to your employees and service providers, you must do so based on a valuation compliant with Section 409A of the Internal Revenue Code (IRC), i.e. a 409A valuation.

By going over your 409A valuation report, you can verify its accuracy. However, 409A valuation reports have value beyond just tax compliance.

A well-crafted 409A valuation report contains valuable insights that can guide strategic decision-making and provide a clear picture of your company's financial health and market position.

By understanding the key parameters within these reports, business leaders can transform a seemingly mundane compliance document into a powerful tool for growth and talent acquisition.

In this article, we cover some of these key parameters you will find in a 409A valuation report.

Parameters to look for in a 409A valuation report

Some of the valuable parameters you can find in your 409A valuation report are as follows:

Fair market value (FMV)

The most important output of a 409A valuation is the fair market value (FMV) of your company’s shares. Your employees’ taxable income from stock-based compensation depends on the difference between the exercise price and the fair market value (FMV). Hence, most companies will first define the FMV through a 409A valuation and then set exercise prices.

Companies would like to set low exercise prices to effectively attract talent as it gives the incoming employees a greater chance to make capital gains. If you feel an FMV does not accurately represent your concerns, you could ask the valuation service provider for another valuation.

Since this is the most important output of a 409A valuation, you will find the FMV in the summary of findings section which is typically placed at the start of 409A valuation reports.

Valuation date

Section 409A of the Internal Revenue Code (IRC) has safe harbor provisions. If a company gets the protection of these safe harbor provisions, the 409A valuation is presumed reasonable unless the Internal Revenue Service (IRS) can prove that the valuation was grossly unreasonable.

The conditions for receiving safe harbor protection are:

• No material events should have occurred since the valuation date
• Less than 12 months should have passed since the valuation date
• One of the three prescribed methods must be used

Hence, the valuation date is very important. To be on the safe side, you must set a reminder to get a valuation about 11 months after the valuation date.

The valuation date, too, can be found in the summary of findings.

Valuation methodologies

Depending on their structures and industries, different valuation methodologies must be applied to different companies to arrive at the FMV. Typically, a combination of or one of the market, income, and asset approaches is used to value a company. In an audit, the IRS will want to know if the valuation methodologies were applied accurately and in a generally accepted manner. If not, the IRS could term a valuation non-compliant with Section 409A which could have severe tax consequences for your employees.

So, it is in your interest to check if the valuation methodology is in line with industry standards and documented in detail.

Assumptions

409A valuations, like any financial valuation, take internal as well as external factors as input. The internal factors would be your company’s financial history, quality of management, and other such company-related factors. External factors such as inflation, expected economic growth rate, and regulatory pressures are factors outside your control.

Most valuation service providers would make accurate assumptions about economic factors. However, inaccurate assumptions regarding industry-specific conditions are possible in nascent industries. If your company belongs to such an industry, you must verify the accuracy of assumptions.

Projections

Nowadays, 409A valuation reports are used not just to comply with tax regulations. Companies recognize that these reports prepared by independent financial experts can provide a valuable unbiased opinion about the company’s expected growth. Thus, companies often ask valuation service providers to include financial projections. One reason for making such a request is to, of course, verify the accuracy. However, another equally important reason is to use unbiased financial projections in strategic decision-making.

Discount for lack of marketability (DLOM)

When a private company is valued through the market approach, the valuation multiple is calculated based on recent mergers and acquisitions (M&As), funding rounds, and valuations of publicly listed companies. However, the shares of the private company, which is the subject of the valuation, may not be as liquid as the shares of companies considered for building the valuation multiple.

Hence, a discount for lack of marketability (DLOM) must be incorporated in a 409A valuation.

If the discount for lack of marketability is not applied or applied insufficiently, your company will end up being overvalued. This is not ideal since it limits your ability to attract talent by making your stock-based compensation less attractive.

On the other hand, if the DLOM is too high, the IRS may suspect that your company is trying to get undervalued so that your employees get away with unfairly low taxable income. This could trigger an audit from the IRS.

Capital structure

A 409A valuation report should include an analysis of your company’s capital structure. The purpose of this analysis would be to identify the impact of preferred shares on the value of your company’s common stock. This impact on the value of the underlying asset, i.e. the common stock, is then incorporated into the final FMV.

You can also request the valuation service provider to include a dilution analysis which will also prove useful for any stakeholder who owns common stocks.

Comparable company data

As part of the 409A valuation, the valuation service provider will end up researching your competitors. After all, such research is required to apply the market approach as well as to form accurate expectations for the income approach.

In the income approach, company growth expectations must be set based on your current and expected market share, and various other industry dynamics.

The valuation service provider’s research on industry dynamics can be valuable for making strategic decisions about inorganic growth, distribution strategies, marketing strategies, financial structures, and product development roadmap.

See what a comprehensive, audit-ready 409A valuation report looks like!

409A valuation reports are more than just a regulatory requirement. By understanding complex parameters like fair market value (FMV), valuation methodologies, and discount for lack of marketability (DLOM), companies can verify the accuracy of the valuation.

However, the report can also assist companies in strategic decision-making. For instance, its capital structure analysis can shed light on dilution scenarios and the impact of preferred shares on the value of common stock. Additionally, the comparable company data section contains research of competitors which can help a company decide how it should handle competition and improve its market share.