Not surprisingly, some lawyers have suggested that Jason and I are now 409A experts and that we have been dispensing 409A advice.  Nothing could be further from the truth – we are merely expressing our opinions as lay people affected by 409A about what we think is going on.  Of course, since lawyers have written us, we feel compelled to clarify.  Fortunately, the IRS gives us a way to do this, as follows:

Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter(s) addressed herein.

Of course, since I’m neither a lawyer or an account, this all feels a little silly.  However, Jason is a lawyer and – well – he thinks it’s patently absurd.  Now, if you want any advice on the best way to watch 24 on Sunday night, feel free to ask.

In the spirit of the New Year, I’m trying to blog the questions that I’m getting that I think could have broad interest.  Here’s another one.  Remember – I’m not a lawyer so this isn’t legal advice.

I have a question regarding the valuation of a startup I’m in and when it takes affect.  When I joined the startup in 2004, I was granted options at $.10 each.  In Oct ’05, we received a term sheet as part our financing efforts which valued the shares at a multiple to the $.10.  We ultimately didn’t sign for various reasons.  I have 2 questions related to this.  

a) Does the event of receiving a term sheet automatically trigger a new price for the options based upon the valuation in the term sheet even if it isn’t signed? While a 409A valuation expert might take into consideration an unsigned term sheet as part of their valuation analysis (similar to them taking into consideration an offer to acquire the company at a certain price), this won’t necessarily trigger a new price for common stock (presumably the stock underlying the options – equal to the option strike price.)  It’s likely the the new investment would have been preferred stock with some additional characteristics (liquidation preference, participation, dividends) that would cause the preferred stock to have a higher price than common stock.  As a result, at the minimum, one has to take into consideration the capital structure of the company when determining the price for the stock options.  It’s even conceivable – based on a formal valuation analysis – that the appraised value of the common stock might be less than $0.10 due to the new proposed capital structure, even though the per share price of the preferred stock that was proposed was a multiple to the $0.10.

b) Given there was lots of pre-work to come up with the pre-money valuation, when would this pre-money valuation take effect? Since the proposed investment was never consummated, this pre-money valuation doesn’t really ever take effect.  It’s merely one data point in the determination of value under 409A (and – in my opinion – a relatively weak one since the deal didn’t occur).

For the lawyers and 409A valuation experts out there lurking, I encourage you to comments on / add to posts like these.

This is our last post on 409A until the IRS issues more guidance or accepts some of the comments it has received during the comment period. In other words, we are “done” with 409A until sometime between tomorrow and next year. While I was hoping to get to 10 posts so I could refer to this series as “My Top 10 Thoughts On 409A” to join in with the top 10 list of 2005 meme, we only made it to 9.  We hope you’ve enjoyed this series (yes – that was sarcastic.)

To wrap things up, we have a couple of questions that we are asking ourselves these days in light of 409A.

How the hell will the IRS audit this? We have no clue how this will actually play out in the real world. Is the IRS hiring a bunch of private company valuation experts? If so, they are going to have to “pay up” as there aren’t enough of these types in the private sector, much less the public sector.  Or maybe these will become new members of the Homeland Security Accounting Compliance Task Force (a newly formed task force that is overseen by the Office of Civil Rights and Civil Liberties.)

What will happen to the valuation reports? Given that valuation reports of private companies will contain a ton of confidential data, what will happen if an employee gets audited and requests the report to fight off the IRS? Does the company have a duty to give the report to the employee? Will the company have to expend resources and work directly with the IRS on a confidential basis? Will these reports “find” themselves out in the public? What about attorney client privilege issues? Mmm – yummy rat hole.

Will the IRS actually respond to any of the comments given to it? Jason has been active with the NVCA and the general counsel / COO group to provide comments and in addition many law firms and accounting firms are drafting their comments as well, but will this all fall on deaf ears? The idea of the internal valuation method being essentially “useless” could drastically change with the right tweaks to the regulation. We got an encouraging early Christmas present from the IRS and are hopeful for an early Easter present also.

Bottom line, have “fun” with 409A in 2006. There is a lot of noise in this area and hopefully we helped quiet some of it (or – at least made the noise more entertaining.)  We’ll post periodically with updates as the proposed rules evolve.

Perhaps the only upside to the 409A panic in the start up world has been some of the urban legends that have already popped up. Jason and I aren’t your lawyers, so don’t take this as formal advice, but if your lawyers are advising you of the following, at least ask some questions. We’ve personally heard some senior partners at big-name law firms say some crazy things regarding 409A. The following are actual quotes. We will not disclose names to protect the innocent, er.. guilty.

“ISOs (incentive stock options) are exempt from 409A, so don’t worry about it, just grant ISOs.” : This is perhaps our favorite statement. In fact, the statement is factually correct, but logically stupid. In order to qualify for ISO status, the grants must be made at fair market value or higher. Given that ISOs cannot be given to consultants, nor are most executives eligible for ISOs, no company will ever get by granting just ISOs. Since NSOs (non qualified stock options) are subject to 409A, there will be some sort of formal valuation report (whether done internally or by a third party) that will determine the fair market value of the stock, which will in turn determine the price of the ISO. In other words, 409A does affect ISOs.

“Restricted Stock is exempt from 409A, so don’t worry about it, just grant Restricted Stock.” : Another factual statement that may work for very early stage companies but just doesn’t work in reality for most companies. When a restricted stock grant is made, the award itself is a taxable event and the grantee immediately holds voting stock. Perhaps granting restricted stock awards to the first half dozen employees of a company when the valuation is extremely low works, but for any somewhat mature start up, this doesn’t make much sense. Note that Restricted Stock Units and other deferred compensations units are subject to 409A. There are some workarounds for 409A, but they are pretty dense and confusing. For example:

“Such units will not be subject to Section 409A if settled (whether in stock or cash) before the later of (i) two and one half months after the end of the employer’s fiscal year in which vesting occurred, or (ii) March 15 following the calendar year in which vesting occurred. If the units qualify as performance-based compensation under Section 409A, the holder may make an initial deferral election at any time prior to the last six months of the performance vesting period”

See, we told you so.

“Directors are personally liable for screw ups concerning 409A.” : Jason was pelted with calls on this after a name-brand firm went around telling its clients this. Frankly, we aren’t sure where this is coming from, because there is nothing specific in the regulations which say this. Our best guess is that this stems from improper withholdings that are associated with 409A blunders. Should the company undervalue its options and therefore subject the employee to income on the spread versus the true fair market value, the company should also make withholding payments to the IRS on this “income.” Traditionally, failure to properly withhold for taxes can be a personal liability of officers and directors, so perhaps this is the chain of thought that elicited this statement. In our opinion, we’d be very surprised if the IRS chose to prosecute except in the most egregious situations, so we aren’t losing any sleep over this.

While writing this, the trailer for the season premier of 24 just aired and we’d rather think about all the dudes Jack Bauer kills this year instead of 409A, so we are done with this post.  Don’t worry – we’re also almost done with torturing you on 409A.

On Friday, Jason and I received an early Festivus / Hanumas gift from an attorney who asked to remain nameless, but we thank him nevertheless. He clued us in to a release from the IRS on December 23rd where the IRS issued some additional guidance related to prior grants. In a nutshell, the IRS said that stock option grants made before 1/1/05 are safe from 409A if they were done in accordance with the good faith valuation rules of the ISO regulations. Furthermore, grants between 1/1/05 and the effective date of final regulations just need to be done under a reasonable valuation method.

So what does this really mean?  Most importantly, it means that 409A is a moving target and the story is changing faster than we can crank out blog posts. We’ll wait for some of the “pundits” to decipher the IRS statements (ya gotta love how everything the IRS releases to give guidance usually causes even more confusion), but it looks like this is a step toward sanity. Best case, as long as the board of directors were doing good analysis of fair market values when making grants, then perhaps past grants (prior to 1/1/05) are effectively exempted out of 409A. This would be huge and welcome relief. See our prior blog on the official NVCA comment letter – this “grandfather” clause was one of the major tenets of the letter.

As for grants done in 2005, this sounds pretty good but no one really knows what a “reasonable valuation method” means yet, so we’ll reserve judgment at this time.

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.

Every VC’s friendly neighborhood trade association (the NVCA – National Venture Capital Association) just submitted an extensive and comprehensive comment letter on 409A to the IRS.  If you are paying attention to this issue, it’s well worth a read.

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:

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.)

This just in from Matt Blumberg, a CEO of one of my portfolio companies that is enjoying pondering what to do about 409A.

She’s real fine?
Or tile cleaning fluid?
No – IRS mess.