Startup Equity: 409A vs Investor Value (part 2 of an n part series)

untitledfWe have all seen the headlines, “XYZ receives $100M in funding at a $3B valuation.” We seldom see the “other” valuation showing the same company is worth $350M. For publicly-traded companies, value is determined by investors working as a group in a real-time market. They are generally purchasing the same kind of stock. Values are based on a combination of publicly disclosed information, supercool computer models and gut feel. But in the world of the pre-IPO start-ups, values take on a life of their own.

Investors in startups are buying stock with more risk and more upside potential. Companies only sell stock to investors on an occasional basis, further changing the value dynamic. Each investor may be able to negotiate the terms and conditions that control when and how their investment will deliver its value or protect the investor from loss. And, larger investors are essentially negotiating directly with the company for 1) the privilege to own stock and/or, 2) the responsibility of giving money to a company who needs it and has no guarantee of returning it. All of these factors contribute to the investor value. If a company has equity compensation plans they must also have a value that meets IRC 409A requirements.

IRC 409A covers a whole bunch of stuff, but for the purpose of this post, we are only going to discuss valuation. The 409A valuation is used to determine the strike price for stock options. The strike price for stock options is a critical element in calculating the compensation expense for stock options. The strike price is also the hurdle that must be exceeded to deliver real value to plan participants. So, if the 409A value is low, it makes stock options less expensive for the company and more lucrative for the holders. Most experienced venture capital investors understand this, but as the number of so-called “unicorn” startups has grown, questions regarding the value of shares have become pretty common.

It can be frustrating for an investor to purchase stock only to see stock options granted with a strike price that is a fraction of their investment price. Often the investor value is a double digit multiple of the 409A. Adding to this confusion is the reticence of startups to consider the potential dollar value of the equity they are granting. It can be equally frustrating for the plan participants. They are attracted to companies with these amazing investor values only to find that the internal value of the company is far less. It can be deflating and confusing.

Compensation professionals must be better at evolving equity in light of extended pre-IPO periods, increasing differentiation between investor value and 409A values and growing concern among some investors that 409A values are kept artificially low at the expense of investors. Communications to both plan participants and investors need to bridge the gap between the low 409A value and the often overly optimistic value of the most recent funding round.

None of this is really new, but the increased values of pre-IPO companies have made it far more common. In 2007, Facebook sold 1.6% stake to Microsoft for $240M. This gave Facebook an investor value of $15B. Almost a year later Facebook allowed employees to sell some stock back to the company at a 409A valuation of $4B. Which was the “real” value of Facebook? Likely none of them in the sense that a compensation professional would like to evaluate. This is what makes equity compensation at startups so interesting and fun.

Use the following as your rule of thumbs (hopefully you have more than 2 thumbs).

  1. 409A values are intentionally depressed to keep costs down and potential up.
  2. Even with Rule 1 in place, smaller companies may find their 409A values higher than expected when the market around them is especially hot.
  3. Investor value is largely based on whether your company is getting the favor of an investment, or giving the favor of an investment. In virtually no situation will this value be closely linked to your 409A value.
  4. Your less experienced investors will always push to have executive and employee equity linked to their own cost of investment. More experienced investors may link equity compensation to the future size of the pie. In a world of leverage, initial values have less impact than future multiples.
  5. But that doesn’t mean that strike prices mean nothing! If your 409A value goes from $0.10 per share to $1.25 per share in a year, is has a BIG impact on two otherwise equal executives who may be getting the same percentage of equity. Use this information as a motivating tool for potential hires on the fence. If you are growing and know that a 409A valuation is on the horizon, then now is the time to join the company.

Please post comments and questions below. I will do my best to include future posts on the topics that readers want covered.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry resources including the recent Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.