If you’re a startup that grants stock options to its employees, chances are you’ve heard of 409A, a section of the US tax code that’s been around since 2004. Section 409A requires companies to properly value stock options they grant employees, which means they need regular audits to establish the value of the common shares they grant. But how do valuations professionals arrive at that magic number? Historically, it’s been a murky process. Here, Steve Liu renders transparent the Solium Analytics approach.
409A valuations and common shares
We read headlines about how a company raised a certain amount at a certain valuation, commonly referred to as the “post-money valuation.” Those valuations are different than 409A valuations. To understand that better, let’s first look at the difference between preferred and common shares.
When a company raises capital, it’s selling preferred shares, which – much like the name suggests – provide additional security to professional investors. The valuations quoted in headlines are the post-money values based on the preferred price, not the common price.
What do we mean by “additional security?” Basically, in the event of a liquidation, holders of preferred shares are first in line to get their money back. Preferred shares also typically give the investor some say in the company strategy, which common shareholders don’t have.
By contrast, companies grant their employees options to buy common shares, and that’s where Section 409A comes into play.
When should I get my first 409A valuation?
Typically, the first time a company would be required to have a 409A is right after it raises its first round of capital or goes through any other type of financing (e.g., convertible debt, SAFE). It is also best practice to refresh the 409A value after each subsequent round of financing. The IRS also requires that companies seek a qualified appraiser, so the process usually starts with finding a valuation provider.
What’s better – a high or low valuation?
409As are used to price options, and those options are used to reward early employees for their risk and to recruit new talent into the company. Management typically wants to grant as many shares as possible at the lowest price as possible to incentivize for long-term wealth creation.
We’re sensitive to that. At the same time, an established framework, such as the one we use at Solium Analytics, takes into consideration the startup’s stage of development and many other factors to arrive at a defensible value. From that perspective, a valuation can be a both art and science to capture the potential upside of the startup as well as the inevitable risks of investing in a developing company.
The Solium Analytics approach: Early-stage startups
Completing a 409A valuation of an early-stage startup right after a financing event tends to be a fairly straightforward process – there isn’t a lot of room for subjectivity as the preferred round provides a concrete basis. This is contrary to traditional valuation methodology where you apply a top-down approach by first determining the business value of the startup, and then use an option-pricing model to distribute value. If there are subjective factors, they usually involve volatility (accounting speak for business risk) and term (time horizon to exit).
Outside of a financing event, we’ll look at the financial projections, with an understanding that it’s easier to compare a mature private company to its public peers than it is for an early-stage company. Valuing startups further away from a round of financing tends to involve more “art”. We give greater weight to financial projections (taking into account the volatility of “hockey stick” growth) and market movement (within the startup’s industry sector).
The Solium Analytics approach: Mature companies
Valuations for mature private companies get more interesting, as the extent to which we rely on certain value drivers changes, as well as an increasing number of factors to be considered. For instance, we rely more on the company’s financial forecast and we consider the company’s public peers to a greater degree, as that’s now a more reliable input.
With public peers, we’re looking at revenue and EBITDA multiples (measure of value which compares the company’s revenue/EBITDA to its enterprise value). And if the company is at a stage where a potential exit is possible, we can factor in M&A comparables, or consider company-specific exit events that may occur (such as an IPO). We can also run a discounted cash flow approach, which combines consideration of the company’s future cash flow and projected financial performance over a 3-5-year time horizon, then uses public comparables to determine a terminal value beyond the discrete forecast period.
Key risk factors examined at 409A
As mentioned earlier, 409A valuations consider the fact that common stock comes with more risk than preferred stock. The risks we look at are usually market-related. Most of our clients are in nascent industries, offering new products and services, so risk is associated with product development and talent acquisition. We consider the competitive landscape. We look into whether the company has raised enough capital to break even or get to positive cash flow. And we consider how the market responds to the company’s products or services that are directly relevant to its growth prospects. When we’re working with later-stage companies, we consider factors like unit economics to a much greater degree. We try to assess the path from scalability to profitability.
409A valuation and secondary transactions
Let’s say the founder and/or employees want to sell their stake or “liquidate” to an investor or another buyer. What price will be used for the transaction, and how does the transaction itself affect the 409A valuation?
The 409A valuation typically will act as a guidepost for the price used in a secondary transaction, especially as the company is growing and looking to execute on a number of secondary transactions that may be priced differently than a common value arrived at by the 409A.
Also consider that a secondary transaction itself affects the 409A valuation – the extent to which depends on circumstances such as orderliness, timing, number of bidders and availability of information. One key factor is whether or not the buyer is the company itself, the current investors or an unrelated buyer.
As a general rule of thumb, the closer a buyer is to the company (e.g., access to information, level of due diligence, board representation), there’s a higher potential impact of that secondary transaction on the 409A. Current investors could have a better understanding of the risk or reward profile of the startup than an external buyer. Of course, as one might expect, there is a myriad of permutations (and other considerations including stage of development, sales frequency and buyer/seller-specific incentives to purchase/liquidate) so ultimately, each secondary transaction has to be evaluated on its own individual merits.
Don’t be a lone ranger
Startups may be tempted to appraise the value of their common stock in-house, but multiple problems can arise. If the valuation does not follow the best practices established by the industry (think AICPA), your auditor may take issue with the valuation and require it to be completed by a qualified valuation service provider. If the shares are valued too low, the options could be considered deferred compensation for tax purposes and be subject to immediate taxes and penalties. And a special caution for mature private companies: If the SEC takes issue with your 409A valuation, that’s serious enough to delay your IPO.
Talk with a valuation provider who you trust, who understands the VC ecosystem from seed to exit. Every part of the cycle has its pain points, and it’s good to know what they are. Ultimately, you may not need a 409A valuation (or you may need one more than you think!), but given the important implications of a stock options for recruiting, retaining and rewarding employees, you deserve to have an advisor help you navigate through that decision-making process.
We can help you get from here to there
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