Vital Role of 409A Valuations in Stock Options Strategies

What is a 409a valuation for a startup?

A company’s 409A valuations determine the current value for your startup’s common stock, which is usually issued to employees as options. To appraise the fair market value (FMV), firms will generally consult with a third party and utilize one of the following approaches. 

1. Market approach: A method of studying the recent sales or comparable transactions of a similar asset in the marketplace. 
2. Asset-based approach: A method for subtracting liabilities from total assets to arrive at a net asset value (NAV).  This includes intangible assets that don’t show up on a company’s balance sheet.
3. Income approach: A method for estimating the value of an asset based on the income the asset generates.  For a company, free cash flows are generally forecasted for 5-10 years. 

The result of the valuation will then establish the strike price, exercise price, or grant price for the options. 

Does a 409A valuation change?

Yes. To properly value the options granted to their employees, companies need to undergo regular audits to establish the value of its common shares.  To ensure valuations fall under the IRS safe harbor rules and avoid being subject to certain IRS penalties, they are conducted annually or each time the company has a material event (i.e. funding round).

The trajectory of the 409A valuations, what’s the trend?

 An important aspect of the 409A is the message the company is sending to its employees. If the employees see the value of the company rising, the morale around the “watercooler” is generally positive. But a collapse in stock price could erode confidence and company culture.

What if your company’s valuation hasn’t changed and there’s no IPO or liquidity event in sight? 

409A’s are synonymous with startups, and privately owned companies.  If your share price is not moving more frequently than every 12 months (IRS requirement), that typically means one thing.  Your company is not raising capital from outside investors (Angels and VCs).  Unfortunately, employees can be misled about the future of the company, so price is often viewed as the most reliable indicator of future performance. 

What should you do if your company is not bringing on new investors, not planning to go public or hasn’t hinted at a liquidity event?  Getting stuck at a company with stagnant options is not an ideal scenario.  If the trajectory of your company’s stock has been trending lower and there are no signs of an exit (IPO, SPAC, Direct Listing), then it may be a wise decision to start exploring firms with more lucrative compensation packages. 

With that said, there are examples of startups that bootstrapped their way to an exit, raised seed money to get to profitability, or waited until a late-stage funding round at an attractive valuation (Meta, formerly Facebook, and EBAY are two examples). Big rounds of venture capital are an important indicator for startup health, but not the only indicator. Even though your company hasn’t had multiple 409A valuations, it might not always be wise to leave the company.    

How are options impacted by funding rounds at a privately owned company?  

When a company raises capital through funding rounds (Series A, B, C, D), it’s selling preferred shares to the Angel Investors and Venture Capital firms. If there’s financial trouble, debt holders and investors who hold preferred shares are first in line to get back their money.  Preferred shares also receive voting rights, which may give them a say in the company strategy.  Therefore, preferred shares are normally priced higher than common shares. 

On the other hand, a 409A prices the shares of common stock and adjusts its valuation based on benefits that wouldn’t be associated with a common shareholder (protection, voting, etc.).  For an early-stage startup, there could be a big difference in the value between preferred shares issued to investors and common shares issued to employees. 

Because it’s very difficult to arrive at the correct valuation, the actual value is generally somewhere between the preferred share value (investor valuation) and its 409A (employee valuation).

 

 If there are funding rounds, should you be worried about dilution? 

If you are an early hire at a company and granted options, then future funding rounds could dilute your shares. But even if your shares are diluted, there’s a good chance it could lead to a much higher 409A.

For example, let’s say your company has a sound business plan and adds value by raising capital.  Then what appears to be dilution and less share value at the onset, could result in a much higher share price in the future.  A startup’s valuation can change dramatically if the company has the working capital it needs to influence growth opportunities (i.e., hiring, building new products, or engaging in M&A activities to acquire competitors). 

Are you unsure about signing the employment contract because you don’t know enough about the stock performance?  

People should inquire about 409A valuations at job interviews.  If you’re in the final innings of the hiring process, it’s okay to ask about the trend of the company’s 409A. It’s a fair question before you sign the dotted line.

Want to learn more? 

Your options are complex.  It may be time to consult with a tax professional or financial planner.  Making informed decisions about your stock options can be a struggle if you lack time, knowledge, or resources.

Little Known Facts:  

• There are two potential values a Founder or CEO is navigating. The lower-priced common shares (409A) that are issued to incentivize employees and the higher priced preferred shares to convince investors what the company is actually worth.  Uber is an example of how significant the difference can be between common and preferred shares when the company is privately owned.

 

• A private company valuation 409A you read about in the media are based on the preferred share price, not the common share price.
• “The thought that ANYONE can be precise about the value of a private company to the second decimal place is preposterous,” Benchmark’s Bill Gurley told the New York Times via text message.

Who can I turn to for trusted 409a valuation services?

With the complexities that come with managing your company stock, it’s crucial to have a strategic plan in place. At Augustus Wealth, we specialize in agile wealth management services in Los Angeles tailored to your unique circumstances. Our experienced advisors understand the intricacies of equity compensation, including the nuances of 409 valuations. 

In addition, we can assist you in implementing a 10b5-1 Plan and lend our expertise to advising on the 83b election, a critical decision that can have lasting implications. Trust us to guide you through the intricacies of your financial journey, ensuring a well-informed and strategic approach to your wealth management.