To be honest, the penalties for 409A Valuation non-compliance are insane; hefty fines, irreversible reputation damage, and a potentially greater tax bill. But they are there for a reason. An inaccurate 409A Valuation can lead to another Enron. We all don’t want that. The IRS doesn’t want companies generating their own 409A Valuation because the likelihood of inaccuracies can by high. That is why there are Safe Harbor provisions for companies who obtain an 409A Valuation from third parties. It’s a win-win situation. The IRS doesn’t have to go through your 409A valuation with a magnifying glass, and in return, you get an accurate, non-biased value of your company. The Safe Harbor 409A Valuation is one of the best assets you can add to your company.

409A Safe Harbor Opportunities

IRS 409A Valuation (Link Here) has two opportunities for startups through which you can achieve a Safe Harbor 409A Valuation. If you meet the conditions of any of these three items, you are considered in “Safe Harbor”. Below is a description of each of the three opportunities:

Independent Appraisal

Binding Formula

Illiquid Startup Safe Harbor

Each of these opportunities are complex and unique. Each provides you with a clear path to achieving a Safe Harbor 409A Valuation. Let’s take a look at each:

Independent Appraisal Safe Harbor

When it comes to the matter of 409A Safe Harbor Valuations methods, the independent appraisal opportunity is among the most common and easiest to pursue. The IRS wants an independent 409A Valuation from a reputable firm that employs consistent, well-documented methodologies in their appraisals (like Five23). This is typically the easiest route to take in securing a Safe Harbor 409A Valuation. Find an independent, trustworthy valuation firm and pay them to do your 409A valuation. What’s so hard about that, right? Turns out, finding a quality fully-independent firm is more difficult than it seems.

Many companies turn to their cap table software providers for a 409A valuation package deal. This makes sense. Your cap table software has access to almost all the data you need to perform a safe harbor 409A valuation. However, even the leading cap table software providers stretch the boundaries on independence. And, in many cases you will run into a conflict of interest. Typically, your software provider doesn’t have the proper authority to provide you with an accurate 409A Valuation. They use old methods which do not require up-to-date financial data, which will eventually lead to an inaccurate 409A. If this is the case, you will find your valuation may be grossly mis-calculated. The IRS may find your company to be grossly mis-valued and take away your Safe Harbor exemption. At this stage you still may be on the hook for the inaccuracies.

Binding Formula Safe Harbor

The binding formula Safe Harbor applies to 409A Valuations based on the consistent use of one, generally-applicable repurchase formula in the company’s stock transfers. The legalese around this provision incomprehensible at best. The formula applies whether those transfers are compensatory or non-compensatory. It’s applied all of a company’s stock transfers and the stock transfers of at least 10% of the company’s shareholders. Additionally, the IRS specifies: any person or issuer holding more than 10% of the combined voting power across all classes of the issuer’s stock is void from this exception. Thus effectively making the provision unattainable for the vast majority of companies (any company which one shareholder owns 10%+ of the companies shares).

The big exception to the binding formula safe harbor presumption are “arm’s length transactions” related to the company’s stock. These are transactions for which both buyer and seller have no prior relationship and act independently of each other’s interests. The actual legislation covering this Safe Harbor presumption states that this generally-applicable formula should apply when used as part of a non-lapsing restrictions surrounding the company’s stock.

In essence, unless your company has a valuation of $100mm+ and more than 100 independent shareholders. You are not going to fall into this exemption opportunity.

Illiquid Startup Safe Harbor

The illiquid startup opportunity to Safe Harbor 409A Valuations is intended to accommodate the startup environment, where equity switches hands on a much more frequent basis. It applies only when both the service recipient and the service provider (typically the “employer” and “employee”, respectively) do not anticipate an IPO within 180 days or a change of control event within 90 days. A ‘Change of Control Event” could be a shift in voting power such that one person or entity holds more than 50%. It could be a liquidation; could be a substantial sale of assets; could be a board call. Point is, you’ll know it when you see it.

Under the illiquid startup presumption, your 409A Valuation must be performed by a “qualified individual”. The IRS specifies a qualified individual to be someone companies can reasonably rely upon based on some combination of knowledge, education, training, and experience (Five23 for example). They further specify this to mean five years of relevant experience.

Failing to Achieve a Safe Harbor 409A Valuation

As stated previously, you should view meeting 409A Safe Harbor requirements as a mandatory part of running your company. While it’s not actually required, the penalties of non-compliance aren’t worth the risk. Not even close. These penalties are exacted on each employee deferring compensation. The employees can be hit with a tax on their income, with the entire balance of their deferred compensation plan applied—for the current year and all past years for which their compensation was deferred. There’s a 20% excise tax on that. On top of that, the IRS charges interest on that 20%. That premium interest rate is roughly 1% plus the federal underpayment rate. Employees are hit with these tax penalties in tandem with whatever fees and fines they accrue in their efforts to pay off what they owe. Basically, get ready to pay a fortune to the government for failure to comply. Luckily, that is why there are Safe Harbor 409A Valuation, and they are cheaper and easier to get than you would imagine.

Safe Harbor 409A Valuation from Five23

At Five23, we pride ourselves on working closely with startups and investors to provide the best service possible. Our 409A Valuations are quick, straightforward, and painless. We give you a simple form to complete with minimal information required. From the time you start the process, we typically complete a 409A Valuation in just a matter of days. In addition, being an unbiased third party. We give provide the Safe Harbor 409A Valuation discussed in this article. 

If you’d like to get started with a 409A Valuation, you can view our packages here (all come with a 409A Valuation). If you’d like to learn more about Five23, please visit our website or send us an email to: contact@five23.io. We’d love to hear from you.

The post 409A Valuation Safe Harbor Guide (2019) first appeared on Five23.

Valuing a Startup

The problem arises when using the comparable transaction valuation method on startups. In many cases, the startup in question has little to no revenue. Therefore, using the comparable transaction method is not ideal in these circumstances. The majority of investors use a Discounted Cash Flow (DCF) method valuing with startups. While this method can work well, it does not follow the traditional framework of a valuation based on the company’s assets, liabilities or past profits. Instead, the startup’s valuation is based on their potential for success using metrics such as growth, active user base and possible profits. In essence, the DCF valuation model uses the concept of time value of money. Typically, future cash flows are factored to the company’s projections of at least three years. These cash flows are then discounted by using cost of capital to give the factoring party a present valuation of the company.

Adding Potential

The largest take away from the typically DCF valuation method for a startup is the need to prove potential. Without potential, the valuation of the venture in question will be quite low. Though having revenue may increase the valuation and the likelihood of receiving investment, the growth potential for future profits is what will drive the investment. A few key growth factors which may be considered by startups to show their potential growth could be:

• Active User Base
• Lifetime Value of Client
• Total Addressable Market
• Organic Traffic

Currently, there are over 50 valuation methods used by investors globally. Although the majority of investors use a DCF method, all of the methods used focus on potential. Therefore defining your venture’s potential in a myriad of areas will give a clearer picture to future investors; no matter what valuation method is used.

The post Investing in Potential first appeared on Five23.

Have you had to raise money for your startup before?

If you are like 99% of entrepreneurs the answer is ‘Yes’. In order to realize a young entrepreneur’s dream of scaling to profitability, funds are needed ─ luckily there are several sources of capital to help fulfill those funding needs. 

Typically, raising money from friends and family is the first step when starting a new business. While they can give you that initial needed boost, it’s more than likely that it will not allow you to see the product to fruition, and then find yourself in the position of raising more funding. Upon reaching this stage, more traditional Angel Investors or Venture Capitalist funding is normally the best option for startups in this position, however, for many the capital is never raised and their dream may stop there. 

Five23 started to look at why so many entrepreneurs never receive funding. There are a few reasons emerging as to why this is happening. In some cases, the idea itself could be the reason why the investors don’t see any opportunity for the startup to advance. Another unseen aspect is the human factor. Many investments are made based on the team behind the company and their ability to deliver goals and handle responsibilities. If investors feel the team can not meet those expectations, the investment will not be made. Finally, the most important of all reasons, which is consistently overlooked, is an incorrect valuation. More often than not, the entrepreneurs overvalue their company by at least 50%. This reason alone is why four out of five startups never realize their dreams. 

When angel investors and venture capitalist look at a company, the first thing they analyze is how much the company is worth. They do this primarily focusing on how the market is growing, what is the future value of the company, possible mergers and acquisitions, etc. When all of these items are weighed, a value is calculated. If this number is more than 20% different from what the startup says they are worth, the investor closes the door. 20% is too great of a difference to overcome in negotiation, and the due diligence process stops before it even starts. 

So how can startups keep the due diligence process moving? The simple answer is by having a correct valuation. If the entrepreneur values their company within a margin of 10% to what the investor thinks the company is worth, they are much more likely to close a deal. 10% in either direction can be justified and agreed to easily. But how can founders do this, how can they standardize their valuation to match that of an investor? 

The solution is a third party. By having an unbiased outsider look over your business plan, financials and team, you obtain a very accurate and realistic picture of what the company is worth. Valuing a company in this manner is very similar, if not the same, to what an Angel Investor or Venture Capitalist would do. This allows you to be in that margin of 10%, giving you the opportunity to see your company reach its goals.

The post The Importance of a Correct Valuation first appeared on Five23.