Startup companies will often offer employee stock options as part of their compensation package to help incentivize hard work and retain their employees. Who wouldn’t want the opportunity to become a shareholder in the company they helped build?
However, until 2005, startups actually lacked the framework to determine the price of these options and employees were being issued options that held an arbitrary exercise price.
Enter IRC Section 409A, which dictates that startups need to regularly undergo a third party valuation study to assign a value to the employee options. Armed with this knowledge, employees are able to follow the growth (or decline) of their option value and make informed financial decisions.
What Exactly Is a 409A Valuation?
A 409A valuation is an independent appraisal of the fair market value (FMV) of a private company’s common stock on a certain date. Common stock is the type of a company’s equity that is typically awarded to employees and founders. Now required by the IRS, private companies commission this assessment to determine the price at which employees can exercise their options – also known as the strike price. In short, the 409A valuation at the time your options are awarded sets the price at which you can purchase your options and become a shareholder in your company.
When Does a Company Conduct the 409A Valuation?
Typically, a company will conduct their first 409A valuation after raising their initial funding round – or any other type of financing. After this first valuation, it is considered best practice for the company to renew the 409A either once a year or after any material change to the company business, whichever comes first.
How Is a 409A Valuation Determined?
The 409A value can be based on several factors, including comparable private and public companies, free cash flow, and the company’s tangible and intangible assets. However, the independent appraisers carrying out the valuation generally favor these two methods when determining the value:
- Comparable companies
This method looks at other similar companies in the industry to determine an appropriate valuation. - Projected cash flow
This method relies on the cash flow of the startup to determine the value. However, this method isn’t always applicable to early stage startups, as they often aren’t profitable enough at that point.
Are 409A Valuations Similar to Venture Valuations?
Although a funding round can prompt a company to update their 409A valuation, it’s important to note that a 409A valuation is completely separate from the valuations derived from a venture funding round. How?
The 409A assessment is a conservative valuation that focuses on how much the company’s most mature, stable product is worth. In a venture valuation, the VCs will also take the company’s potential into account, which usually increases the value. If the company has promising candidates, a unique selling proposition, or innovative projects in the pipeline, the venture valuation will likely be higher than the 409A valuation.
Is It Bad if the 409A Valuation Ends up Being Lower Than VC Valuation?
Because the 409A valuation determines the option’s strike price, it can actually be beneficial for you (though maybe not for shareholders!) when it is lower. A low 409A price when the options are granted will give you the opportunity to ultimately exercise them at a lower price, assuming the company valuation rises. This can make it more affordable for you to become a shareholder in the company you helped build.
We know that exercise costs can be steep and many employees often leave their jobs without the means to exercise their options. However, a low strike price can help combat this issue and make exercise costs more manageable.
Ultimately, what determines your earning is the gap between your strike price and the price of the shares when you liquidate them. For example, if your options are granted at a lower strike price (as a result of a lower 409A valuation) and the company exits at an increased valuation, you could gain higher potential earnings.
What Does It Mean if a 409A Valuation Decreases?
A decreased 409A valuation is not a good thing, but that doesn’t necessarily mean that a company is doomed or that there are no advantages to the situation. A 409A valuation is impacted by a variety of factors, some intrinsic to the company’s performance and others extrinsic, such as the current state of the market. While it is possible that a decreased valuation could indicate negative company performance, it could also just be reflective of a down market. This is why it’s so important for investors, including employees, to do research on both the company and the markets when making investment decisions. There’s no way to predict with absolute certainty what will or won’t happen, but understanding the cause of the downward pressure can help one make an informed decision and be able to more accurately determine if the 409A drop is an opportunity or a red flag.
Whether it’s internal, external, or a combination of factors lowering the 409A, if the company rebounds and regains that value, the drop can be advantageous to employees by lowering strike prices on new grants (both initial and refreshers) and potentially decreasing tax liability. Of course, if the company fails to rebound, a decrease would simply result in paying less for a less valuable asset.
What Does It Mean if a 409A Valuation Increases?
An increase in the 409A valuation is generally a good thing for shareholders, including employees, as it represents an increase in the common stock’s value. As the company grows more successful, the 409A valuation should increase as well depending on both intrinsic and extrinsic factors. While the increase is a positive thing, it does also result in higher strike prices for new grants and increased tax liability. This increases exercise costs, but the underlying asset is more valuable. It is important for you to be aware of any changes in your company’s 409A valuation.
It’s a good idea to ask your company when they expect to reevaluate their 409A so you can make informed decisions regarding when to exercise your options appropriately. Please note, however, that these valuations often aren’t planned or scheduled. A material event, such as a funding round, may happen, which can trigger a new valuation to occur unexpectedly.
Conclusion
While a low 409A valuation might initially seem worrying, don’t panic! There are a lot of positive opportunities that can arise from a lower 409A valuation – especially if your company’s valuation ultimately rebounds.
Companies should issue options fairly based on their real time value at the time of issuance. A low 409A valuation, and strike price, at the time of issuance can be beneficial to the employee if the company continues to increase in value. Don’t know the 409A valuation at the time of your options grant? Make sure to ask so you can make the best financial decision when it comes to exercising your options down the line!
