In terms of the administrative and regulatory overhead of running a startup, the need to conduct a 409A valuation makes for an interesting discussion.
The concept of this IRS rule is simple: a company must value its shares fairly and price its options accordingly. Options issued below the fair market value create a taxable event as value is conferred upon the recipient at the time of grant. And, if the appropriate taxes are not paid at that time, the company can later be subject to a stiff penalty while the employee would be responsible for taxes and interest. Not fun.
The subject of 409A valuations is intimidating. If you’re thinking about doing it yourself, it is easy to get caught up in the various frameworks and techniques: Black-Scholes, lattice, Monte Carlo, Probability-Weighted Expected Return Model, market-based, income-based. Furthermore, the literature and guidance online highlight the dangers of making a mistake — a failed IRS audit resulting in draconian fines and terrible tax consequences for employees who were granted options.
So, surely it makes sense to drop up to $25k for a qualified, experienced, outside professional to conduct the evaluation, thereby automatically creating a safe-harbor protection against penalty?
Here’s the thing: much of the literature online is authored by firms trying to sell their expertise. With one exception, the entirety of the first page of Google results for the search term “409A Valuation” is comprised of firms attempting to sow fear, uncertainty, and doubt in order to peddle their services. Their message: this is a scary process, but, fortunately, qualified experts can help.
Here’s an interesting tidbit that isn’t shared so widely by these vendors:
In the decade-long history of the 409A rule, there hasn’t been a single instance of an audit by the IRS on a startup’s option valuation.
What are the odds that you’re going to be the first — particularly if you act reasonably and in good faith?
Here’s another interesting fact:
Provided that a valuation was done by a “qualified individual”, the burden falls on the IRS to prove that the valuation was “grossly unfair.”
So…. in the highly unlikely event the IRS decides that your startup will be the first that it takes enforcement action against, so long as you had an appropriate level of competence to perform an evaluation, it’s still an uphill battle for the IRS to prevail.
From my standpoint, I love the 409A valuation as it has allowed me to dust off one of my favorite parts of my education: options pricing theory. I am always waiting for occasions to show that learning the Capital Asset Pricing Model and efficient frontier hypothesis was going to pay off.
In valuing Gain Compliance’s here are the steps I followed:
I calculated the expected value of the company — essentially a probability-weighted expected return (PWERM) of the outcomes in a five-year time horizon.
I calculated the discount rate using the volatility (beta) of a cohort of publicly-traded SaaS companies with publicly available data:
I used the calculated volatility to discount the expected value back to present value given the expected time to liquidity:
I further adjusted the present value to incorporate a discount due to a lack of marketability (DLOM) for the shares with the aforementioned Capital Asset Pricing (CAPM) model:
I then adjusted for cash and debt to assign a final enterprise value, and then divided by the number of shares outstanding.
In short, you could say I used a PWERM model to generate expected value, calculated a market-based beta and plugged this into a CAPM model to arrive at a present value, and then applied a DLOM calculation.