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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Does Your VC Understand 409A?

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I guess it is only fair that while Jason and I rip on the IRS, accountants, and lawyers regarding 409A, we make take a few shots at the VC community.  VC’s are perhaps the most uninformed population with respect to the 409A guidelines. In general, it’s been very disappointing to here other VCs speak about the regulations and make grotesque over-generalizations regarding their applicability. At this point, I can’t remember how many “this isn’t right” emails that I’ve had to send. At least I have a blog that I can send them to (of course – not for “official advice”), as opposed to having to type the same email 100 times.

Following is an example that came up last week that made my head spin.  One of our companies – a relatively young one that has only had one round of financing - is in the middle of raising a new financing.  They are doing well, have a competitive financing situation going on, and I expect they will have multiple options to choose from.   The company is well informed about 409A, has done all the things you’d expect them to, and are planning to have an outside audit done by the end of April.  The financing is expected to close by the end of March – they are holding off on the 409A audit to wait for the financing to be completed.  They have decided to hold off granting any new options until after the financing and have accepted that the option price will be driven by the 409A audit based on the new preferred stock price associated with the financing.

One of the VCs they are talking to has asserted that they cannot close a financing without an outside audit. The assertion from the VC is that “it’s too risky and creates too much liability for the new investor.”  Huh?  In addition to being a completely illogical statement, it’s clear the VC simply doesn’t understand 409A since holding off on the financing will likely drive the value of the common stock down (since the company is running out of money) while doing the financing will drive the value of the common stock up (since it’ll be well-financed at a higher per share price then before.)  Which is a more conservative position to take?  Actually, it doesn’t really matter – since it’s an early stage companies we are likely talking about pennies a share in any scenario.

Add one “point” to the “noise” column under 409A. It blows my mind that major business decisions (e.g. the financing of an early stage company) are being driven by the IRS guidelines. Shame on you IRS, but more shame on the VCs who remain ignorant about the real facts.

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