Episode 16: Let’s Talk About 409A Valuations

We get a lot of questions on 409A Valuations here at CGL. These valuations are very important to startups and founders in the early stages. As a CEO, it is your duty to make sure these are done in a reasonable and defensible way. 

So if you’re at this stage or have questions about 409A Valuations, this episode will be helpful for you. We are answering many of the common questions we get around this topic. Specifically, we’re discussing 409A Valuations as they relate to privately held companies. Tune in to learn all about this important business process.

In this episode, you will hear:

• Why a 409A Valuation is important.
• How they became a part of the tax code.
• Why these valuations can be problematic.
• How often you should do a 409A Valuation.
• The data needed to perform this valuation.
• The 3 steps that go into performing this valuation.
• Three methodologies you can use to calculate enterprise value.
• What the Black Scholes Model is and how to use it to calculate the value of your stock.
• The role of your auditor in performing a 409A Valuation.

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Transcript from Episode 16:

SUMMARY KEYWORDS

valuation, company, stock, determine, enterprise, approach, typically, privately held companies, evaluation, comps, fair market value, calculate, questions, trading, publicly traded companies, events, early-stage companies, common, process, option

00:02

I’m your host, Hannah. I’m Tom, and I’m one of the founding partners of CGL. What if you could speak with top business leaders and CEOs about their professional insights and personal journeys? Each week we share authentic discussions with business leaders, where they flesh out substantive issues while also getting deeper into their authentic stories. Our goal is to bring you conversations on the fusion of business and humanity, success and authenticity, and the challenges of balancing life and work. Thank you for joining us. Hello, hello, and welcome to another episode of conversations with CGL. I am your host, Hannah Genton. I don’t know if our audience knows this. But my co-host and co-founder norm is out on maternity leave. So I am flying solo today. In recording today’s episode. One of the things that I wanted to talk about today was some recurring questions that we get on certain topics from clients, I thought it would be helpful to dive into an episode about this kind of recurring questions and provide some helpful information. Today we’re talking about something called a 409A valuation, we get a lot of questions on 409 A valuations here at CGL. And I thought that it would be useful to go through some of those common questions and answer them here. Today, we’re talking about 409A valuation specifically as they relate to privately held companies. So let’s dive in here. One of the first questions is, what is the 409A valuation? And why is it important? So 409 a valuation is particularly important to startups and early-stage founders that need to figure out the value of their company’s common stock. So in order to structure something like stock option grants as tax-free events to your employees, which a lot of startups want to do, you need to prove what you calculated as the fair market value of that common stock is actually reasonable. And this is known as a safe harbor under Section 409 A of the Internal Revenue Code. And so for a privately held company, the 409A valuation is the only method that a company can use to grant stock options on a tax-free basis to its employees. So maybe kind of a bit of history here. So a common question we get is okay, so how did that even become part of the tax code, and prior to 2007, stock option grants were actually not considered taxable events. stock options were typically only taxed when an employee actually exercised his or her options to buy the common stock. So this all changed after Enron, you may remember what happened there. So Enron executives who are granted large stock awards, accelerated the vesting of that stock and their stock options, and then exercise and sold stock when Enron’s shares were trading at an all-time high. So this happened, even though the executives knew that they were actually overstating the value of the business to drive up that valuation. And Enron highlighted some of the loopholes that weren’t covered by the existing insider trade laws. And so as a response to that the Internal Revenue Code Section 409A was passed, and it was passed as part of the 2014 American jobs creation act. So that’s a little bit of history as to where that comes from and why that is relevant to private companies today.

03:25

Okay, so then another question that we get is about the 409A valuation and kind of how problematic it is. So let’s go into that. So why does a 409A valuation create problems for companies, especially startup companies, so companies can largely ignore section 409A if they give employees stock options that have a strike price exactly equal to the fair market value of the common stock at the time of the grants. So for publicly traded companies where the fair market value is the current stock price, this is easy, this is easy to determine. But for privately held companies like startups, this isn’t as straightforward. So as Section four, a nine eight has evolved, certain provisions were created so that privately held companies can determine the fair market value of their common stock in a way that would be more accepted as valid by the IRS. So this is that safe harbor that I mentioned earlier. But these new standards of proof are different from how privately held companies had previously determined the fair market value of their common stock. So in the past, a company would decide on its own what it felt was an appropriate price for its stock, but now a company has to provide substantial supporting evidence for that and that’s where the 409A valuation comes into play. So Another common question that we get is okay, I understand the importance of a 409 evaluation, how often should I do it? How often does my company need to do a 409 evaluation, typically a 409A evaluation should be done at least once Every 12 months this valuation should also be done if any kind of material event has occurred that would affect the value of your company’s stock. Remember, this is a process to determine the reasonable price of the company stock. So some examples of these types of material events could include the issuance of new equity, secondary sales, or if there’s been kind of a significant change either good or bad to the financial situation of your company, we have a bunch of other scenarios to that you can reach out if you have specific questions about an event and whether it would trigger the need for a 409 a valuation. But as a company approaches an IPO for nine a valuation should actually be done more frequently on a quarterly or even a monthly basis. Again, if you have specific instances in your company that you want to explore more, we can certainly chat with people about that. And we guide our clients on that all the time. Okay, so now we’ve got a little bit of background about a 409. A, and why is it important? Another question we get before we kick off kind of guiding plants through this process is what data is needed to calculate the 409A valuation. So usually, the data needed to perform these valuations is pretty straightforward. I can go through this list briefly, so we can get kind of to the actual calculation. But typically, a company is going to need to determine their business sector industry, they will need to provide formation documents of the entity like your charter or your Articles of Incorporation, which should include information about the company’s stock, oftentimes, a company will need to provide its most recent cap table, any board or presentation pitch deck recently prepared the company historicals and PnL. Cash Balance debt projections, it’s best typically to have three years, but it’s understandable that like an early-stage company wouldn’t necessarily be able to provide three-year predictions. So that kind of depends on the company, and where it’s at also a little bit of forward-thinking kind of documentation, and usually a list of five or more publicly traded companies that are most comparable to your company. So these are typically what’s referred to as trading comps. And ideally, the trading comps shouldn’t change from valuation devaluation unless there’s a substantial change in your business or the business of one of the trading comps. So, for example, a substantial change would be if one of those trading comps was acquired, that’s obviously a pretty material event and substantial change, and then any timing expectations around potential liquidity events, such as an IPO or acquisition. And finally, any significant events that have happened since your last four on a valuation, I realized this is a lot, we have a list of these things, this isn’t something that you have to memorize, just trying to give people some visibility into the types of things that are requested prior to calculating a 409A valuation. So say your company has gone through this process, they’ve collected all this data. Now what happens what are the next steps. So as soon as a company has gathered all this data, the valuation modeling begins. And this typically involves three steps. The first step usually tries to determine how much the company is worth.

08:12

This is called the enterprise value. Arguably the most important step in a 409A valuation is estimating your company’s enterprise value. So this is done first and can be straightforward immediately following a capital raise. But it becomes less clear down the road because there’s more kind of events going on and things. The second step in the process is to determine the value of the company’s common stock. So this is done by taking your company’s enterprise value and dividing it among all your different share classes to determine the fair market value of your common stock. So the different classes of stock your company may have issued can include preferred stock warrants and common stock, this step is set up to take into account all of the economic rights of each of these share classes. So that’s kind of part of the valuation process. And then the third step, and the final step is to apply a discount to the fair market value to take into account the fact that the stock isn’t publicly traded. So just a reminder that everything we’re talking about here today is applicable to private companies. Okay, so the first step, as we just mentioned, and this is we’re gonna go into kind of some of the deeper details here, but the first step in the foreign nine evaluation is to determine the enterprise value of the company. So let’s look at this a little bit more closely. So how is enterprise value determined in a 409A valuation, so the first step in the 409A valuation process is to determine how much your company is worth. So there are three main methodologies typically use to calculate enterprise value and a 409A valuation these three methodologies are referred to as market income and asset-based approaches. These three methodologies can be used in combination with each other and the methods you use may change as your company develops. So for instance, it’s common for early-stage companies. to rely heavily on the market approach, while a more mature growth stage company can be more likely to use an income approach. So let’s kind of break this down a little bit and walk through these methodologies to determine enterprise value. So let’s start with the market approach. How does the market approach work? So the market approach is typically used for early-stage companies that may not be profitable yet and can’t predict long-range financial performance. So this approach is not a relative valuation method, which means that the company would be compared to a group of publicly traded companies that are similar to it by industry. These are called trading comps and trading comps are used to determine the appropriate valuation multiple to apply to the company’s own set of metrics to arrive at an enterprise value. So for profitable companies, this is typically something like you know, an accounting multiple, but in the case of early-stage companies, say like where that accounting measurable, maybe negative revenue multiples are used. So what’s the benefit of this approach? The benefit of the market approach is that it’s really easy to calculate publicly-traded company multiples. So the limitation is that these trading comps may not be a great representative peer group. So for example, an early-stage company is usually at a different scale and growth rate compared to its publicly traded comp. So therefore, adjustments need to be made to take into account that the comparison isn’t perfect. So that said, if your company has just completed a capital raise, determining the enterprise value is fairly easy. The valuation of that round is often used, and this is typically called a back solve. A back solve is considered a market approach for calculating enterprise value because the rounds valuation is used back in the valuation. Okay, so then the next approach for determining enterprise value is the income approach. So let’s walk through the income approach. What is the income approach used and how does that work? So the income approach can be used when a company has achieved some visibility and predictability in their financial performance and profitability is more foreseeable. The income approach assumes that a company’s value is determined by the receipt of future profit streams. So the company’s long-range financial projections are used to determine what these income levels are, which are then discounted back to the present value. So you may also hear the income approach referred to as the discounted flow method. The benefit really of this approach is that it’s directly influenced by the company’s future expected profits. But a major disadvantage of this methodology is that requires reliable long-range forecasts that need to be substantiated. So sophisticated financial planning systems must be in place. So this approach may not be as applicable as the first approach that we mentioned. That could be you know, easier to use for early-stage companies who maybe don’t have sophisticated financial planning systems in place. Okay. And the last methodology for determining the enterprise value is the asset approach. So let’s talk about that one, what is the asset approach.

13:04

So the asset approach uses replacement costs to determine a company’s enterprise value. So for this method, the appraised value of all the assets and liabilities of the company is what determines its enterprise value. So the benefit to this approach is that it doesn’t require any kind of forecasting because the potential growth of the company is actually completely ignored in this process. But that benefit is also a downside. Additionally, it can be really expensive to appraise certain assets and liabilities, especially IP assets. So the asset approach actually is probably an impractical method for early-stage companies to use. Okay, first, I realized that that was a lot. So again, you know, this is why you work with a reputable kind of foreign nine, a valuation firm, and a law firm to guide you through the process. But again, if people have questions about any of this, please feel free to reach out to us and we can go through it a little bit further. So those are the three methods for determining the enterprise value of the company. But in terms of the foreign nine, a valuation process, like where are we, where are we and what are the next steps. So once a valuation firm has gone through that process and determined the company’s enterprise value, that’s what we were just talking about. The second step in the 409A valuation is to determine the value of your company’s common stock. So in the case of a company with only common stock, this is easy. The fair market value is the enterprise value divided by the fully diluted shares outstanding. However, as you may know, many privately held companies will have at least two if not more classes of equity. So say a company has series ABC and D shares and preferred shares for these companies. Calculating the fair market value requires further analysis. So this is typically done by assigning various equity classes to the fair share of the company. And this will take into account economic rights such as things like liquidation preferences, participation. Conversion ratios. There are different ways to allocate the enterprise value across these multiple share classes. But the most common is one that perhaps you’ve heard of this is called the Black shoals model. So this is certainly kind of thrown about in the startup community. So let’s run through the Black Scholes model, what is it? So black shells is the most commonly used option pricing model and a 409A valuation, this model typically calculates the value of a stock option by averaging all of the possible future profit on that option strike price. So, in other words, like to put it more simply, and that’s when a stock option would be at or in the money. So for a 409A valuation, a handful of key assumptions drive the output of the Black Scholes model. So this is the enterprise value of the company, which is what we’ve been talking about volatility and expected time to exit. So your company’s volatility is determined typically using the set of those publicly traded companies that we talked about, which are your trading comps. But the more volatile a stock is, the higher the chances that the options will expire in the money, which increases its value. And then the last piece is the expected time to exit. And this is really like the amount of time until a liquidity event.

16:18

So the longer the time to exit, the more valuable the options since oftentimes more time gives the option an increased chance to expire in the money, if that makes sense. So that was a lot again, and I think kind of just the final piece to discuss as a last step in the 409 evaluation, which I mentioned earlier. And this is to apply a discount for lack of marketability to the common stock value calculated. So equity allocation models assume that there’s an active market to immediately trade the common stock, which is the case for publicly traded companies. But because this isn’t the case, for a majority of the privately held companies, their common stock is less valuable. So there’s a lack of marketability, that’s what it’s called, which has been taken into consideration for these privately held companies. And so to adjust for that lack of marketability, a discount is applied to calculate the fair market value. So this lack of marketability actually decreases as your company matures and becomes more successful. So an early-stage startup that has no interested buyers, and its common stock will have a very large discount, whereas a company that’s a credible candidate for an IPO has a very small discount. So you can see how those two play together a really important piece to raise in this process is the auditor and the auditor’s role we get this question a lot is how involved should my auditor be in my companies for nine a valuation involving your auditor early in this process is really helpful and can help ensure a smooth process. So best practice, I highly encourage you to include your audit team and the kickoff call with your four nine evaluation consultant prior to conducting a new 409 evaluation. It’s really important like anything to get everyone on the same page, make sure that everybody agrees to be approach and the valuation methodology, which is what we covered here in this episode. And they’ve found that your auditor say identifies a flaw in the valuation that you use to grant the options there require you to revisit and potentially revise not just that 409 a valuation but also prior evaluations. So as you can imagine, this could be a really lengthy and painful process. And any option grants that are outstanding could be put on hold until the four or nine evaluations are sorted out. So again, best practice is just to make sure that everybody’s on the same page and aware of what’s going on.

18:46

So you know, kind of as a final point here, it’s just really important for our listeners to understand, and I want to remind everyone but as a CEO or a founder of your business, you have the ultimate duty to ensure that the valuation work done is reasonable and defensible, because the IRS can challenge that analysis, even if it’s performed by an independent provider and reviewed by your auditor. So again, just going to the point of how important this process is and how mindful CEOs need to be as they’re managing this for their companies. I realized this was a lot of information and went into a lot of details kind of hard as I’m just talking here on my own. So if people have additional questions about this, you know, we help clients navigate this all the time. I hope this was helpful in answering some general questions, please feel free to shoot us a note at info at CGL dash LLP comm if you have any more questions, and we look forward to speaking with you next time thanks.