409 A White Paper If you are a CEO or a CFO of a high growth startup, it is vital to understand how to value your company correctly. Here is a quick list of questions this lunch will help you answer: Do you offer or are you planning to offer your employees stock options? Do you know the difference between ISOs and non-ISOs? Do you understand the general valuation concepts and approaches that the IRS has outlined, especially as they apply to early-stage companies? Did you know that if you run afoul of the 409A rules, your employees could have an unpleasant tax surprise and that some of that responsibility could revert back to you as the employer? Do you know if and when you need to engage an outside expert to assist with a valuation? www.thecapitalnetwork.org

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Section 409A – Common Stock Valuation
WHAT IS SECTION 409A?
As part of the 2004 American Jobs Creation Act, section 409A of the IRS Code states
that private companies should not issue stock options that are “in-the-money,” or with
an exercise price that is below “fair market value.” Failure to comply with this
regulation results in a 20 percent tax penalty for the option recipient (in addition to
their applicable income tax rate) on the difference between the option’s strike price and
the fair market value of the associated security. This tax is due in the year the options
are granted, whether or not the options are ever exercised.
HOW DO YOU BEST COMPLY WITH THE REQUIREMENTS OF
SECTION 409A?
The IRS has instituted a safe harbor provision for this law, which provides that a
formal valuation performed by an independent valuation firm will be accepted as a
valid method for determining the fair market value of the company’s common stock.
This avoids potential conflicts of interest and provides transparency into the fair market
value calculation.
Once an initial valuation has been performed by an independent appraisal firm, the
regulations require that the valuation opinion be updated every 12 months, or any time
there is a material change to the business.
HOW IS THE FAIR MARKET VALUE OF YOUR STOCK
DETERMINED?
The IRS and the American Institute of Certified Public Accountants (AICPA) have
issued guidelines for valuing the common stock of privately held companies. These
guidelines suggest that valuation experts use the market, income, and cost approaches
to determine the firm’s total equity value. Equity must then be allocated among the
various classes of stock using one of three methods: the current value method, the
probability weighted expected return method, and the option pricing method.
Valuation experts discourage the practice of discounting the latest preferred round
share price to determine the value of common stock. This approach fails to account for
the firm’s capital structure and the volatility of the firm’s value.
Cost/Asset
Method
Securities
Transactions
Public
Comps
M&A
Comps
DCF
Enterprise& EquityValuation
Option Pricing
(Black-Scholes)
ProbabilityWeighted
Expected Return
Current ValueMethod
FMVofCommon Shares
ABOUT SCALAR ANALYTICS
Scalar Analytics is a leading provider of independent
business valuation and transaction advisory services
to growth equity companies and private equity firms.
We are committed to providing accurate, independent
valuations that meet the standards of your auditors
and board members. Our Company also boasts the
fastest turnaround times in the industry.
Other services include ASC 718, ASC 805 and ASC
820 valuations; merger and acquisition advisory;
intellectual property valuations; and secondary private
equity transaction advisory.
CONTACT SCALAR ANALYTICS
Alicia Amaral, Managing Director
One Broadway, 14th
Floor
Cambridge, MA 02142
E: alicia.amaral@scalaranalytics.com
O: (617) 684-5510
WHAT IS THE PROCESS FOR A 409A
VALUATION?
Once you have retained a qualified, independent
valuation expert, the process usually involves brief
interviews with management and a review of
company financials and documents (executive
summary, capitalization table, articles of
incorporation, etc.). The valuation expert will use this
information to conduct a formal valuation and issue a
report stating the conclusions.
WHO USES THE VALUATION?
Board members and executives use the 409A
valuation report to determine the appropriate strike
price for stock options issued as compensation to
employees. The reports are subject to review by audit
firms for expense and tax reporting purposes. If your
company goes public, the SEC scrutinizes all stock
option grants to determine whether or not the exercise
price of each grant is defensible, often referring to the
409A valuations of independent appraisers. The
valuation report may also be used in court if there is a
lawsuit concerning option grants and the fair market
value of common stock.