409A – The Valuation Process

You may ask yourself “why are Brad and Jason so hung up on 409A – it just seems like yet another accounting thing my CFO is going to have to deal with.”  Wrong – it’s going to impact every employee in your company that gets stock options and is something every board member and the CEO needs to understand clearly. 

We’ve been entertained several times in the past two weeks as we’ve heard stories from board meetings where outside company counsel (from reputable law firms) have said such absurd things as “don’t worry about 409A – just grant all your options as ISOs – 409A doesn’t apply to ISOs.”  We’ll explain later why this is such a stupid statement, but for now we still have some work to do to set up the plot.

If you read our first post on 409A – Government Maximus Interruptus – you know by now that if a private company doesn’t accurately value its options, there is deep doo doo for the option holder and company. We’ll save the issues related to inaccurate valuation for another post (yeah – it’s kind of hard to implictly foreshadow with stimulating topics such as 409A – limiting our ability to impress the screen writers for 24, so we’ll just be explicit.)

So how do you correctly value options in the startup world? What does the IRS think? Under 409A, the IRS says you have three choices:

  1. Do it the old fashioned way (company board determines in good faith the FMV), but if an option holder gets audited and the IRS thinks the strike price is not truly FMV, then the option holder has burden of proof to show otherwise. If (when) you lose, have fun.
  2. Have a person, internal to the company who has “significant knowledge and experience or training in performing similar valuations,” create a written valuation report detailing the accurate pricing of the common stock. The quotes are directly from the IRS regulation and if you can explain the parameters of “significant knowledge and experience or training in performing similar valuations“ to us, please comment freely. The big issue is no one really knows who qualifies to do the valuation and what the report should look like. Many of the finance people at the startups that I know – even the extraordinary ones – probably don’t have “significant knowledge and experience or training in performing similar valuations” and – even if they did – why would they take the risk (remember – the finance dudes are supposed to be conservative.)

  3. Hire an independent, qualified, experienced valuation firm to create a written valuation report. Voila – the IRS and the accounting industry just helped create a new cottage industry! This is still tricky, as outside of the traditional valuation firms, it’s unclear who is qualified to perform the valuation. Furthermore, even if startups were willing and able to hire the legacy valuation companies (at $40k a pop), there aren’t enough valuation people in the world to get all of this work done in a timely matter.

The “good news” for options 2 and 3 is that if you follow the procedures correctly (whatever that means) the IRS has the burden of proof to show the valuation was “grossly unreasonable” which is an almost impossible standard to meet. So that essentially forces companies to choose one of the last two options.  However, in option 2, you have to prove that the internal person doing the valuation is “qualified”, but since the IRS hasn’t given guidelines for this, it’s a risky proposition. If the IRS decides the person isn’t qualified and/or they didn’t follow a “reasonable” methodology (again – unspecified), this makes the burden of proof in option 2 essentially sit on the company.  As a result, rational actors are going to default to option 3.

Therefore, as a result of 409A, we are now in a world where every private company that issues stock options has to get formal valuations from time to time. So what’s the big deal?

  • Cost. On the high end these valuation can cost $50,000 or so. Considering that the company must value options at every grant date, this can get incredibly expensive.  We have some suggestions for how to solve this issue economically, but that’s a later post (more foreshadowing).

  • Competency. Not wanting to be left out of the “entrepreneurial spirit of Silicon Valley,” smaller valuation companies are popping up all over the map to perform these valuations at substantial discounts to the established players. The problem is that few firms (and very few people) have a great deal of history or experience in valuing private companies, so the verdict is out whether these reports will be acceptable to the IRS should they come knocking. We are getting multiple calls a day from people wanting to perform valuations and most of them we wouldn’t trust to give us change back from a cash register. (As an aside, one of our companies recently completed a formal valuation and the valuation firm (presumably a reputable one) forgot to take into account liquidation preferences of the preferred stock when considering common stock payouts on mergers.  Once they did this, it reduced their initial valuation by 75%.  Oops.)

  • History. The “grandfather clause” for 409A only applies to options that have vested by 12/31/04.  As a result, any option that is still unvested (or granted) after 12/31/04 has to be “fixed” (yes – another post).  Therefore, if you are a typical private company that has four year vesting on stock options, you’ve got to fix option grants that go back as far as 2001.  Groovy.

  • Uncertainty. The big question that everyone is grappling with is what will the results be from these formal valuations? Will they be 10 times higher? Could they even be lower? No one really know the real impact of the valuations, because no one really knows how these firms will value the companies. We’ve seen a couple reports so far and in one case the price was actually lower than the company was granting at, while the other company was significantly higher. Uncertainly, however breeds nervous people.

So bottom line, startups will have to get formal valuations done on their common stock. It’s not pretty, but it’s probably here to stay. We’ve been working on a standard process for our portfolio companies and are pretty close to having one that we recommend.  Remember – we are just suggesting ideas, not providing legal advice, check with your lawyer, even if they are clueless about this stuff and – if they are – we’re happy to recommend some that we think have a clue.)