When startups offer stock options to attract talent, they need to figure out the worth of their common shares. For privately-held companies, the only way to issue these options tax-free to employees is through a 409A valuation.
But for many, understanding a 409A valuation can be challenging, as its methodology has significantly changed since it first came out 15 years ago. It has transitioned from a mix of outdated approaches and vague estimates to a more refined process with clear methods and criteria.
At its core, a 409A valuation involves a three-step process. Initially, it assesses the total value of the company, known as the "enterprise value." Next, this value is distributed among the different types of equity to determine the fair market value (FMV) of common stock. The final step involves applying a discount to the FMV to reflect the fact that the stock is not publicly traded.
This explanation is geared towards companies based in the U.S., specifically Delaware C-corporations, offering straightforward call options (with a set expiration date and strike price, without unique terms) to employees within the U.S.
To make stock options grant a tax-free benefit for your employees, it's crucial to validate that the fair market value (FMV) of your common stock, which you've determined, is indeed reasonable. This validation process is known as achieving "safe harbor."
The simplest and most reliable method to secure 409A safe harbor is by having a qualified, independent firm perform the 409A valuation. This is similar to how a mortgage lender hires an appraiser to impartially assess the value of your home rather than taking your word for it due to the potential for bias in your estimation.
However, it's important to note that even with professional valuation, safe harbor under 409A is not automatically guaranteed.
As a CEO or founder, you're responsible for ensuring that the valuation is credible and defensible. This is because the IRS and the SEC, where relevant, may scrutinise the valuation, even when it's carried out by an independent entity.
Choosing the right 409A valuation firm is crucial for ensuring your stock options meet safe harbor requirements. Look for a firm that not only possesses the necessary credentials and valuation expertise but also has a deep understanding of your industry, sector, and business stage.
For example, if your business is a rapidly expanding enterprise SaaS company in Silicon Valley, avoid a valuation provider whose main clientele consists of slow-growing, profitable, brick-and-mortar businesses in the Midwest.
This mismatch can be likened to selecting a tax accountant for your personal income taxes; you'd ideally want someone who's not just a certified CPA but also has a wealth of experience handling tax returns for individuals with financial situations similar to yours, thereby maximizing your tax benefits while minimizing the risk of audits.
Moreover, opt for a valuation firm that maintains robust relationships with the big audit firms, including the Big 4 (Deloitte, PWC, KPMG, and E&Y) or significant regional firms in your area, particularly those with connections to the heads or partners of the venture practices. This indicates that the valuation firm's work is both defensible and respected within the audit community, offering additional credibility to your valuation.
It's required for companies to complete a 409A valuation at a minimum annually or more frequently if a significant event takes place that could change the company's valuation, whichever comes first.
Significant events encompass occurrences such as receiving new equity financing, getting an acquisition proposal, specific situations involving secondary sales of common stock, and major shifts in the company's financial prospects, whether positive or negative.
Additionally, companies on the path to an initial public offering (IPO) often undertake 409A valuations with greater regularity, such as every quarter or month.
To conduct a 409A valuation, you'll need to gather a set of essential information and work closely with your valuation provider to ensure they understand your company's specifics and any unique situations.
If you've gathered all the necessary documents listed previously, completing a 409A valuation and preparing it for your Board's approval typically spans around two weeks.
The usual process includes the following:
Following this, the third week is generally reserved for securing Board approval and proceeding with option grants.
For many startups, reaching an annual revenue of about $10M marks the point where investors start to expect audited financial statements. Given that the 409A valuation significantly influences the calculation of stock compensation expenses, it's inevitable that your auditor will want to review it. Engaging your auditor from the beginning of the 409A valuation process can help ensure that the subsequent audit proceeds smoothly.
It is advisable to involve your audit team in the initial discussion with your 409A valuation provider. During this meeting, it's crucial for all parties to agree on the valuation approach and methodology.
For valuations that are particularly complex, or if an Initial Public Offering (IPO) is anticipated within two years, auditors might ask their valuation specialists to examine a draft of the 409A valuation before it is finalised for Board approval. Incorporating this step can extend the timeline by at least a week.
Achieving consensus early on is essential. If your auditor later finds an issue with a 409A valuation used for option grants, you may have to reevaluate not only the current valuation but also previous ones. This reevaluation process can be extensive and challenging, and it may pause any pending option grants until the 409A issues are resolved.
This section outlines the three key steps involved in conducting a 409A valuation.
Estimate the Enterprise Value: The initial, and often considered the most critical, step is to determine the company's overall value, also known as the "enterprise value." This task is relatively straightforward following a funding round but can become more complex as time passes from the last fundraising event.
Value the Common Stock: Next, the enterprise value is allocated across all classes of shares (e.g., preferred shares, warrants, common shares) to establish the present value of the common stock, or what's referred to as the "fair market value" (FMV).
This process accounts for the economic rights associated with each class of shares, including liquidation preferences (the sequence in which investors recoup their investment during a liquidity event) and rights related to conversion, dividends, and participation.
Adjust for Lack of Marketability: The final step involves applying a discount for lack of marketability (DLOM) to the calculated FMV of the common stock. This adjustment reflects the reality that the company's shares are private, meaning that employees cannot readily sell their shares on the open market due to the absence of a liquid market.
Calculating the enterprise value of a company is a foundational step in the 409A valuation process, with several methodologies available to financial experts, such as M&A specialists, equity research analysts, and venture capital firms.
The choice among these methodologies often evolves as a company grows, with three primary approaches employed: market, income, and asset-based, which can be used singly or in combination.
After establishing the enterprise value, the process continues by allocating this value among the various classes of equity, factoring in economic rights such as liquidation preferences and participation rights.
For companies that only have common stock (a rare scenario for privately held, venture-backed companies), determining the FMV involves simply dividing the enterprise value by the total number of fully diluted shares. However, venture-backed companies typically have multiple classes of equity, such as Series A/B/C/D preferred shares in addition to common stock, making the FMV calculation for common shares more complex.
Here are the three primary methods used to distribute enterprise value among different share classes, listed from most to least commonly used in venture capital-backed companies:
The final phase of a 409A valuation involves adjusting the value of common stock for its lack of marketability, referred to as the Discount for Lack of Marketability (DLOM). The valuation methods employed in the preceding step presume the existence of a readily accessible market for selling the stock, akin to publicly traded shares. However, for most private companies, this is not the reality, leading to a reduction in value due to the challenges in selling these shares.
The impact of marketability on a company's stock value diminishes as the company grows and approaches a public offering or another liquidity event, making its stock more appealing to potential buyers. For example, a company in its early stages, such as post-Series A, might find very few interested purchasers for its common stock, necessitating a substantial DLOM. Conversely, a company on the verge of going public or achieving significant scale may warrant only a minimal discount.
The time anticipated until a liquidity event significantly influences the extent of the DLOM. The duration an investor is expected to hold shares before being able to freely trade them is a critical consideration. Studies on DLOM typically suggest a discount range of 25%-35% for holdings expected to last two years. Higher discounts may be justified for longer wait times until a liquidity event.
In scenarios utilising a backsolve method, the DLOM might be lower than these standard ranges. This is because the 409A valuation in such cases aligns with a preferred stock transaction, where the price set by venture capital investors already reflects a degree of marketability restriction inherent in these investments.
The idea that the fair market value (FMV) of common stock in private companies can be set at 10-20% of the most recent preferred round price needs to be updated.
This approach, once a common shortcut used by private companies, their Boards, and legal advisors to determine option strike prices, is no longer considered accurate or reliable. Even for companies at the early, seed-stage, it's rare for the FMV of common stock to justifiably be a mere fraction of preferred stock value.
If you're advised that your 409A valuation should be a specific percentage of the preferred stock's value, you're receiving advice based on an antiquated principle.
The reality is that with a thorough 409A valuation analysis, it's possible to determine the FMV of common stock on a whim accurately. No universal "rule of thumb" applies, as the valuation depends heavily on each company's unique situation. There have been instances where valuations appeared surprisingly low but were justified upon closer examination of the preferred shares' economic rights.
Conversely, there have been cases where the FMV seemed excessively high yet was found to be reasonable due to substantial company advancements since the last valuation or a legitimate change in valuation methodology.
Using a forecast for your 409A valuation that differs from the one presented to your Board is no longer a viable strategy.
In the initial period following the introduction of 409A valuations, some companies attempted to use lower financial projections for their valuations to minimize the assessed value of their common stock.
However, the forecast provided to your 409A valuation provider should be the authentic forecast used in board communications.
The legitimacy and reasonableness of the assumptions in your valuation are critical, and the company's forecast is one of the primary elements reviewed to ensure accuracy.
Providing a forecast that aligns differently from the one used for business operations can lead to significant complications with auditors and jeopardize the 409A valuation's safe harbor protection. This discrepancy poses a substantial risk to your employees by potentially invalidating the valuation's compliance.
Striving to secure the lowest possible strike price for stock options may seem advantageous. Still, the impact of minor adjustments to the strike price on the eventual financial benefits for employees during a significant liquidity event is often minimal.
To illustrate, let's examine a scenario where an employee receives 100,000 options at a strike price of $0.35. If, after six years, the company exits and the common shares are valued at $50 each, the employee's pre-tax profit from this grant would be:
Now, consider if the strike price had been $2.00 instead. The pre-tax profit in this scenario would be:
Although the strike price difference from $0.35 to $2.00 seems substantial (a 471% increase), the actual impact on the payout is relatively minor, amounting to a 3% difference.
The essential insight to derive from this is the importance of maintaining perspective. The value of the common stock will reflect your company's growth and progress. It's crucial to avoid actions that might jeopardize your 409A valuation's safe harbor status, as such missteps could expose your employees to severe taxes and penalties.
Should the fair market value (FMV) begin to feel burdensome from a recruitment standpoint, considering a stock split to lower the strike price to a more attractive level is a viable strategy, rather than resorting to tactics that could undermine the integrity of your 409A compliance.
The option strike price cannot be lower than the fair market value (FMV) determined by the 409A valuation but may be set higher.
Regulatory and tax bodies, such as the IRS and SEC, are primarily concerned with strike prices set below the 409A FMV. For the IRS, setting a lower strike price implies employees received stock options at a discount, which would be taxable at grant. For the SEC, it suggests a potential understatement of stock compensation expense, artificially inflating profitability.
There are scenarios where setting the strike price above the 409A FMV is strategic, significantly if the company's value has decreased since the last valuation. This might occur when the previous 409A valuation no longer reflects the company's current performance or during a down-round.
In such situations, companies might choose to maintain the strike price at the previous valuation level to support employee morale. However, it's crucial to approach this decision with a clear understanding of future expectations and confidence that any downturn in value is temporary.
For startups not facing an imminent audit, the temptation to adopt an aggressive 409A valuation might seem low-risk compared to the potential scrutiny faced by larger, more established entities.
However, as a company grows and succeeds, this approach can lead to a challenging correction in fair market value (FMV) as the need for a more realistic valuation becomes unavoidable.
This shift can result in a disparity among employees, where early hires benefit from significantly lower option prices compared to those who joined shortly after that despite the company's situation remaining the same. Such disparities create an environment of "haves" and "have-nots," fostering resentment as employees inevitably compare their compensation.
This division can persist, resurfacing in future discussions about pay and potentially affecting the company culture in the long term.
Failing to comply with 409A regulations can lead to substantial employee tax implications. Should the IRS examine and find a company's 409A valuation outside of the safe harbor provisions due to incorrect valuation methods, all stock options granted to employees could be treated as immediate gross income.
This includes options from both the current and any previous taxable years, accruing interest and potentially incurring a 20% penalty on options vested before the tax year in question.
For instance, consider an employee granted 100,000 options at $0.25 each, vesting over four years. If, two years post-grant, the IRS concludes the $0.25 FMV was not safely harbored due to valuation inaccuracies, deeming the actual value at $1.00, the financial burden on the employee could be significant.
Here's a breakdown of the potential federal tax and penalty obligations for the employee (excluding state taxes and federal interest):
• Federal tax rate: 37% (assuming the highest bracket for a single filer in 2020)
• 409A penalty: 20%
• Strike price of options: $0.25
• FMV at year two review" $5.00
• Shares vested after two years: 50,000
• Taxable income: $232,500 (50,000 shares x [$5 - $0.25])
• Federal income tax: $86,025
• 409A penalty: $23,750 (20% of 25,000 shares vested prior year x [$5 - $0.25])
• Total federal obligation: $109,775
This sum, which the employee must pay in cash, arises regardless of whether the options have been exercised or sold. It's a direct result of the options being granted well below the IRS-considered FMV, leading to significant taxes and penalties on vested options.
Additionally, future tax liabilities increase as the FMV of the options rises:
This scenario emphasizes the critical importance of accurate 409A valuations, as the tax implications extend beyond federal to potentially include state and local taxes, significantly affecting employees' financial well-being.
During the due diligence process of an acquisition, acquirers scrutinize your 409A valuations closely. Poor 409A practices can reflect negatively on your company, adversely affecting the negotiation process.
If the acquiring party has concerns about the legitimacy of your 409A valuations, they might adjust the transaction terms to ensure they're not liable for any mispricing consequences. They could also demand indemnification against related risks or require the company (or its employees) to cover any resulting penalties and taxes.
In the context of an IPO, the SEC examines option issuances from the 12 to 18 months before the offering. A substantial discrepancy between the option strike prices and the anticipated IPO price might lead the SEC to conclude that options were issued below their actual fair market value, signaling they were "in the money."
This scenario would necessitate an accounting adjustment for "cheap stock," a disclosure that could negatively impact investor perception and be interpreted as indicative of management's quality.
Your 409A valuation reflects your company's development and the shareholder wealth growth. It's crucial to collaborate with your 409A valuation provider to ensure an accurate valuation. However, avoid the temptation to employ dubious methods or assumptions, as this can lead to significant and unintended repercussions.
A 409A valuation should not be approached as an exercise in minimizing stock appreciation to keep the common stock's fair market value (FMV) as low as possible since the last assessment. Adopting such a stance implies that your company has made negligible progress in creating value, a claim easily refuted by examining key performance indicators and financial results.
It's important to understand that each 409A valuation is interconnected, reflecting the company's growth trajectory. If your revenue is increasing rapidly, but your 409A valuation doesn't reflect this growth proportionately, it raises questions—unless there's a complex structure to your preferred equity that justifies it.
Instead, view your 409A valuations as chapters in the story of your company's journey. The FMV of common stock should ideally show a consistent upward trend, echoing the company's achievements. Properly managed, the increase in your common stock value underscores your company's value proposition and motivates and attracts employees by demonstrating a clear path to wealth creation.
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