409A vs. ASC 820 explained: Understanding the differences in valuation standards for VC-backed companies

Two key standards often come into play when venture capital firms assess valuations: 409A valuations and ASC 820. These standards are not merely regulatory hurdles; they are essential tools that influence how firms evaluate investments and communicate financial health. While both approaches have very similar methodologies, they serve different purposes that are important to delineate. 

In this blog, we’ll explore the differences between 409A and ASC 820, offering insights into their roles and implications for venture capital firms.

409A valuations

409A valuations are primarily used by private companies for employee stock-based compensation and tax purposes. Established under Internal Revenue Code, Section 409A provides guidelines for determining the fair market value of private company stock. This valuation is crucial for ensuring compliance with IRS regulations, helping companies determine the cost basis for equity compensation and associated expenses. 

Key features of 409A valuations: 

• Purpose: 409A valuations are designed to provide an estimate of the value of a company’s common stock and options, primarily for tax compliance and employee stock option pricing. 
• Frequency: Companies conduct 409A valuations annually or whenever there is a significant change in the company’s financial situation. 
• Methodology: The valuation process often involves a combination of market, income, and asset-based approaches, with an emphasis on conservatism to ensure compliance. 
• Outcome: The result is a fair market value that serves as a baseline for financial reporting and tax purposes. 

ASC 820 standards

ASC 820, also known as the Fair Value Measurement standard, is part of the Generally Accepted Accounting Principles (GAAP) and focuses on providing a framework for measuring fair value in financial reporting. Unlike 409A, ASC 820 emphasizes market-based information over entity-specific data, prioritizing transparency and consistency in valuation practices. Furthermore, venture capital funds typically apply principles from ASC 820 to valuing the investments they own—primarily Preferred Equity, which has materially different mechanics than common shares.

Key features of ASC 820 standards: 

• Purpose: ASC 820 is designed to ensure accurate and consistent fair value measurements for financial reporting, enhancing transparency for investors and stakeholders. 
• Frequency: Fair value measurements under ASC 820 are typically conducted quarterly or annually, depending on the reporting requirements. 
• Methodology: ASC 820 categorizes inputs into three levels based on observability and reliability with Level 1 inputs being the most reliable and Level 3 inputs requiring significant judgment. 
• Outcome: The result is a fair value measurement that reflects the price at which an asset or liability could be exchanged in an orderly transaction between market participants. 

Aumni’s Venture Capital Valuation Policy Best Practices Guide identifies the key considerations for the application of valuation policies, including whether or not 409A valuations align with the fair value of holdings outlined by ASC 820. You can download the guide here.

Implications for VCs

Understanding the differences between 409A and ASC 820 is crucial as compliance with these standards ensures accurate financial reporting and tax compliance. For startups issuing employee stock options, 409A valuations provide a necessary baseline for pricing and tax compliance. Meanwhile, ASC 820 standards offer a comprehensive framework for fair value measurement, supporting informed decision-making and investor confidence. 

For venture capital firms, leveraging these standards effectively can enhance transparency, reduce the risk of regulatory inquiries, and support strategic decision-making. By understanding the nuances of each standard, firms can ensure accurate valuations and maintain stakeholder trust.