The 409A valuation process may not be the most exciting thing on a startup founder’s to-do list, but it’s critical to your company’s long-term success. You can’t offer equity to employees without it, and you need to update it at least once a year.
With inflation at a 40-year high, rising interest rates, and volatility in the market throughout 2022, you might also need to consider updating your 409A even if you aren’t “due” yet.
In this article, we’ll walk you through some key considerations for founders as they navigate their 409A. You can also learn what a 409A valuation is or download a sample 409A report before getting started.
What you’ll learn:
- The difference between 409As and post-money valuations
- When you need to have a 409A
- Five questions to ask when deciding to update your 409A
Download sample 409A report
409A valuation vs. post-money valuation
There are two main types of valuations for private companies: a post-money valuation and a 409A valuation. Both help you understand how much your company is worth, but in different ways.
A 409A valuation:
- Is used to determine the fair market value (FMV) of one share of your company’s common stock
- Sets the strike price for options issued to founders, employees, contractors, advisors, and anyone else who gets common stock
- Is based on guidelines in the Internal Revenue Code
- Is typically determined by a third-party valuation provider
- Protects employees from taxes and IRS fines if done correctly
A post-money valuation:
- Is determined by the price of preferred shares, which are more valuable than common stock
- Is based on how much investors paid for their ownership stake during a fundraising
When is a 409A valuation required?
409A valuations are only good for up to 12 months, so if no material events occur within one year of the prior valuation, you should request a new 409A each year. You might need a 409A valuation:
- Before you issue common stock options to your first hire or advisor. Generally, you should get your company’s first 409A valuation before you issue your first common stock options (which are typically granted to your first hire or advisor).
- After any material event. Material events are most frequently a financing round, but can also include any significant operational or financial change—including changes in the economy.
Should you update your 409A because of the changing market?
So is the changing market a material event for your company? A lot of variables can impact your valuation—including financing terms, the macroeconomic environment, and public market volatility.
The recent uncertainty in the public markets is likely to have an especially dampening effect on venture financings and valuations, with investors reconsidering their appetites for risk. Based on Carta data, some companies have delayed plans for an IPO or have seen their own 409A valuations decline. This change in the market might be an opportunity to grant options at a lower strike price (though that may not happen for every company). Recently, Instacart slashed its own 409A valuation significantly—from $39 billion to $24 billion.
Here are five questions for founders and management to ask during market uncertainty:
1. Did you raise capital in late 2021 or early 2022?
The market conditions in late 2021 to early 2022 were significantly more favorable than they are today. If you raised capital during this period, you may be eligible for an equity adjustment that could potentially lower your valuation.
2. Have you made significant changes to your forecasts?
Most companies will be affected by a prolonged downturn. Your finance team may be preparing revised forecasts. As you reforecast, it’s often appropriate to reassess your value to account for these changes.
3. Are you considering raising capital in the foreseeable future?
If you’ve been planning to raise capital this year, you might be facing a dwindling cash balance at a time when capital is either expensive or (potentially) unavailable.
4. Are you slowing down your cash burn given the funding market?
If you have less available cash, you may need to be reassessed for the risk associated with limited funding.
5. Are you planning an exit in the next 12 months?
The road from private to public is taking a lot longer as the IPO market has slowed due to market volatility. You’ll likely need to revisit any assumptions you’ve made about the expected time to exit—especially if you operate in an industry that’s seen a significant decline in the public stock market, like technology.
How startup founders can navigate the 409A process
There’s no “one size fits all” recommendation for your 409A valuation strategy. Every company and scenario is different. With everything going on in the market, it’s a good time to talk to your valuation provider and legal advisors about whether it makes sense to update your 409A valuation now. (If you’re a Carta cap table customer, 409A valuations are included in your subscription on an annual basis and after material events.)
Carta has valued hundreds of billions of dollars worth of assets for companies. Learn more or schedule a demo today.
Kick off the 409A valuation process today
This article was originally published on May 24, 2019.