Assessing Fair Market Value (FMV)
A company may have very little revenue early in its life. It may even be “pre-revenue”. Although investors may invest at a certain price, Stock Based Compensation (SBC) is traditionally given at a discount to this valuation. As a company matures and/or completes its first round of outside financing, it enters a stage where it needs to get a 409A valuation. The 409A is a section of the U.S. tax code which governs how a company awards SBC. Even companies that do not raise outside financing may need a 409A valuation if they intend to issue SBC to their employees, board members, or advisors.
What's a 409A Valuation?
The 409A valuation is an independent assessment of a company’s common stock valuation. Third-party valuation firms such as Andersen Tax, Economics Partners, and Carta conduct 409As to set a valuation for your company and determine what common stock is worth at a given time. This is because common stock is used as the primary form of SBC. If you are confused by common stock, you can read more here. In short, common stock is the most basic type of stock and is issued to founders, employees, and advisors via SBC. Investors may invest in a company, and instead of receiving common stock, they receive preferred stock. You need a fair value for your company’s shares in order to issue SBC. As described later, the 409A helps set the share price used for SBC.
The process for conducting a 409A is straightforward. A third party looks at a number of factors internal and external to the business, including a company’s historical financial performance, its forward-looking projections, and the valuations of comparable companies that may have been acquired or are listed publicly.
Receiving a 409A is important because it sets a price on SBC. However, the 409A has no bearing on the valuation an investor ascribes a company when they invest in or acquire a business. It is best practice for your 409A to be at least one-third of your most recent private market valuation by an investor in case you are audited. It would be suspicious if an investor values your company at $100 million, and you are claiming the company is worth $10 million when you issue stock to employees.
If you are considering joining a company, knowing the 409A and the subsequent common stock price where your options are struck (your exercise price) is valuable on its own. It is most helpful if you know it in relation to the most recent preferred stock price. Read more about our recommended questions to ask when understanding SBC in your offer letter here.
The 409A Valuation and Fair Market Value
The 409A sets a valuation for a company, which is used as the Fair Market Value, or FMV, for a company issuing SBC. Each class of stock - common shares, Series A preferred shares, etc. - will have its own FMV share price as a result of the 409A. Because different classes of stock have different rights, the share price will vary. Preferred shares tend to contain rights such as anti-dilution provisions, rights to a board seat, and liquidation preference, so they tend to have a higher share price than common shares. Remember that common stock is the class of stock held primarily by founders and employees. The spread between the preferred stock price and the common stock price stemming from a 409A valuation serves as an advantage for the company granting SBC to future employees. As a company gets a new 409A valuation each year, its FMV adjusts accordingly.
