What is the Difference between 409A Valuations and Venture Capital Valuations?

Clients often come to us with questions about 409A valuations vs. valuations in venture capital financings. They are sometimes concerned that, if they receive a low 409A valuation, that will set the valuation for a future financing. Thankfully, companies generally do not need to be concerned about this. Below is an explanation of this common point of confusion, starting with a brief discussion of 409A valuations.

What are 409A valuations and why are they important?

Most early-stage companies use stock options to incentivize employees, directors, consultants and advisors. Stock options can help a company attract talent and retain and reward its service providers; by granting these service providers stock options, the company is giving them an economic stake in the appreciation of the company. Consequently, they are motivated to act in ways that help the company grow, which in turn causes the company’s stock to appreciate in value and facilitates long-term wealth creation for both the company and the service provider. However, the use of stock options as compensation and as an incentive for US taxpayer recipients involves a number of complicated legal and tax issues under US law, one of the most important of which is compliance with Section 409A of the Internal Revenue Code.

Section 409A, among other things, imposes punitive additional tax on the recipient of stock options whose exercise price is less than the fair market value (FMV) of the underlying shares on the date the board of directors approves the grant (subject to some exceptions that are beyond the scope of this article). When companies issue stock options to US taxpayers that do not comply with Section 409A, this can result in major adverse tax consequences for the optionees, and significant due diligence problems for the company in future deals. To avoid the severe consequences of noncompliance with Section 409A, it is common for private startup companies in the United States that issue option grants to US taxpayers to regularly obtain independent third-party valuations of their stock from licensed valuation providers, and to use these valuations for setting the exercise price of the stock options. If the Board reasonably relies on these valuations in setting the stock option exercise price, this provides a “safe harbor” under  Section 409A that the valuation method and application of that method were reasonable – thus shifting the burden to the IRS to demonstrate that the valuation method or application thereof was unreasonable. These third-party valuations are commonly referred to as “Section 409A valuations” or simply “409A valuations.”

How does a 409A valuation compare to expectations?

If you are surprised that your 409A valuation reflects a price per share that you consider to be very low (for example, a few cents per share), you are not alone. It is not uncommon for founders to be concerned that a relatively low 409A valuation may indicate that investors will put a low value on the company in a financing. However, there is no need to fret – 409A valuations are different from venture capital valuations in some key respects.

A low 409A valuation does not mean a low venture capital valuation

A 409A valuation is an estimate of the FMV of the company’s common stock established by an independent third party. The independent third party valuation will often include discounts for minority interests and lack of marketability.  A venture capital valuation, on the other hand, is established through negotiations between investors and founders and is used to establish the price per share of a new series of preferred stock in a financing. That series of preferred stock will typically have additional rights which make it significantly more valuable than common stock (including, e.g., a liquidation preference, which gives the preferred stock superior downside protection relative to common stock). Because the 409A valuation and the venture capital valuation are used to price different classes of stock in different contexts, these valuations are in a sense “apples and oranges.” It is, therefore, very rare for a future investor to be influenced by a 409A valuation such that it “anchors” a venture capital valuation negotiation.