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An inevitable question to ask is “okay, the valuation firm came back and said the FMV of the last option grants should have been $.25 and the grant price was $.10. Now what do we do?” Good question. Unfortunately, we don’t have a good answer until the IRS gives us more guidance. But here is what we know so far.
Despite the fact 409A is not a final regulation and is still subject to the comment period (more on this later), the IRS says that if you have a 409A “problem” you can fix it by December 31, 2005 (enjoy your holiday “break”) by electing one of the following:
- Exercise of Discounted Stock Options. The option holder can exercise (early exercise) the option prior to year end and not be subject to 409A. Where all of these people are going to come up with the money to do this, is beyond us. And why anyone exercises and holds private company securities, is also beyond us (ok, we get the “capital gains argument” or the “I’m no longer with the company but want to own stock” argument – these are both rational reasons vs. 409A compliance.)
- Compensation for Increased Stock Option Price. The company and option holder can elect to increase the exercise price of a problem option and the company can make a cash (or other) payment to the participant to compensate for the lost discount. Uh, sure – not such a good use of company funds, especially in a private company that is losing money.
- Replacement of Discounted Stock Options with Cash or Stock. The parties can replace a discounted stock option with a cash or stock grant that complies with 409A. The cash payout is a non-starter, the replacement might be a good idea, but there are tons of other issues with replacing / repricing options.
Now remember, you need to get all of this done by year end. And again there aren’t enough valuation firms in the world to get the valuations done before year end, so even if these weren’t preposterous “fixes” everyone is still screwed.
So what if you don’t fix problem options by December 31, 2005? It’s unclear to us at this time. The IRS says that one has until the end of 2006 to at a minimum raise the option prices of grants to FMV. Note that if the option price changes it blows ISO status (although we’ll discuss why this doesn’t matter later) and will likely severely piss off option holders. We are also hearing a lot of “noise” ranging from “you’re screwed, there is no tomorrow” to “don’t worry about it, the IRS will never audit any of this despite 409A.”
After 2006, it’s strict compliance and nothing can be fixed, presumably.
So given this, what to do about past option grants? Should you skip the holiday dinner and “fix them?” Our opinion is “no” because the fixes aren’t feasible (plus, holiday dinner is yummy.) You have all of 2006 to decide what/if to go back in time and look at each grant date and re-evaluate the FMV at that time. Given our previous post on what it costs to get a valuation done, this is quite the harrowing thought.
We are still looking out our own portfolio to decide what to do. On a case by case basis, we’ll have to look at the company after getting the first formal valuation done and see how different that number is compared to previous stock grants. If the valuations are radically different, we may indeed have to formally value past option events and make changes where necessary.
While we’ll be spending plenty of time talking about 409A in the abstract, Jason and I thought we’d give you a real life example of the analysis for one of our portfolio companies. Following is the essence of an email I received from one of my colleagues last week about a company of his that went through a formal valuation process for 409A.
For those of you who have portfolio companies going through an external valuation analysis as a solution to 409A, we are just completing the process with Company X and wanted to let you know about some of the issues that you may want to be aware of. While the analysis still has not been finalized, the price per share that was determined by the external consultant went from $0.43 after the first iteration, down to $0.10 in the most recent turn. Clearly this process is as much art as science and can have a meaningful impact to both the company as a whole and the individual shareholders. With respect to the analysis:
- The valuation consultant used the AICPA guidelines from the practice aid called “Valuation of Privately-Held-Company Equity Securities Issued as Compensation” as the template for their analysis.
- The analysis uses a basic DCF model to determine the enterprise value, and then Black-Scholes to derive the option value of common shares.
As a result, even if the enterprise value is determined to be less than the liquidation preferences, common shares can be assigned significant value due to this valuation methodology. While the most obvious issue is getting the DCF model correct (e.g. discount rate, exit value, etc) some other big levers that changed the valuation for $0.43 to $0.10 were:
- The valuation company did not take into account properly the liquidation structure; in particular, they did not realize Company X Series A shares were participating preferred.
- A very high volatility coefficient was used as part of the Black Scholes model, thus dramatically increasing the option value of the common shares.
- The valuation company did not properly model the debt.
The difference between the initial valuation for common shares of $0.43 and the final valuation of $0.10 is obviously very significant. While I’m sure the valuation consultant “appreciated” the help, in a perfect world it shouldn’t be necessary. However, we clearly aren’t living in a perfect world, especially when it comes to 409A.
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:
- 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.
- 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.)
- 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.)