What is the meaning of a 409A? TechCrunch

What is the meaning of a 409A? TechCrunch ...

Stripe and Instacart's internal valuations have been updated in a 409A appraisal process in the past few months. Both companies saw their valuations reduced by 28% and 38%, respectively, as a result of the appraisals.

What do these repricings indicate for other late-stage, pandemic-spurred businesses? How seriously should we be taking them, anyway? We spoke to Carta, AngelList, EquityZen, and others to understand the 409A process and why tech firms might want a lower valuation at this time.

What is the meaning of a 409A?

Since the Enron scandal, 409A appraisals have become commonplace across the tech industry. In response to some of Enron's executive misdeeds, Congress passed Section 409A of the IRS tax code that governs how companies offer stock options to their employees.

Kevin Swan, Morgan Stanley's co-head of global private markets within Morgan Stanley's workplace solutions division, told TechCrunch that while it's not required for companies to obtain 409A appraisals, the IRS has made them all but mandatory for private, venture-backed enterprises.

Swan said the IRS advises firms to use a fairly determined reference valuation to determine a strike price for restricted stock units (RSU) and options they offer to employees. If a company does not do this, the IRS will have to assume its own fair market value.

While most public corporations may just issue RSUs and options at a strike price equal to their share price at the time of their issuance, private companies do not have public share prices they can reference to ensure their valuations are fair.

Phil Haslett, the founder and chief strategy officer of EquityZen, told TechCrunch that all tech businesses that have raised more than $5 million or more than 10 employees will go through the 409A valuation process at least once a year.

When a business is in a position to seek a new 409A valuation, it is likely that a significant event may affecting their worth, such as a new investment round, an acquisition, or (ahem) a major market downturn.

409A valuations are both completely distinct and often quite different from the implied valuations determined by investors in a funding round. Although a funding round can induce a company to seek a 409A assessment, the 409A valuation itself is performed by a third-party company similar to an auditor.

These companies usually take into account other factors than those of VCs. Founders basically argue that since investors are buying a different kind of stock, they are also buying into a different kind of valuation.

A fact that a lot of businesses will not state out loud, but that it is common knowledge, is that 409A valuations almost always come out lower than recent funding round valuations, according to Haslett. In other words, the 409A is a conservative valuation, while an external valuation chosen by investors may be more lofty.

One explanation for this discrepancy is that entrepreneurs acquire preferred stock. This is because they tend to ascribe higher valuations to their portfolio companies than a 409A provider would, because common equity is usually valued at a discount to preferred stock until a company goes public. However, 409A valuations are generally quite rare, because changing preferred stock as well in a 409A process is tedious and therefore, rare.

The second difference lies in the valuation methodologies and underlying projections used in the 409A process.

A third-party company will typically use two methods to assess whether or not a business is worth more than it does. The first is the comparable companies technique, which looks at other industry players to determine an appropriate valuation multiple for the business being assessed. The more mature the startup, the greater the impact public stock prices can have on the startup's valuation.

The 28% valuation reduction in Stripes is significant, but it is dwarfed by the declines some of its public competitors have suffered over the years. Block, previously known as Square, is down about 80% from its 52-week high, while PayPal has seen its value decline roughly the same amount in the period. Shopifys stock price has declined about 82% since it was launched in 1953.

Haslett said he expects things to happen if youre Stripe right now. One thing is definitively true, which is that publicly traded fintech firms that are likely to be your peers or your competitors traded at significantly lower valuations than they used to. The second might be that you have revised your advice upwards or downwards depending on the new environment youre in.

Haslett explained that the second method to measure a 409A is cash flow valuation. It's a common method used by auditors and bankers to evaluate businesses, but it's not always applicable to early-stage companies because it relies on cash flow projections, and many of these companies aren't profitable.

More importantly, corporations will often deliberately give their investors a more balanced set of financial projections than they give them. This is in order to reap the benefits of having a low 409A valuation. However, Swan cautioned that companies must tread the fine line of sending auditors projections that are sufficiently low to avoid red flags.

Is it reasonable to have a low 409A valuation?

Yes. Especially for employees.

When a company's valuation falls and the public notices it, it's usually seen in a negative light. A valuation decrease usually indicates that the company is struggling or that investors are concerned about market conditions, according to Haslett.

Many founders and industry experts consider a 409A valuation that is lower than its investor-assigned valuation a boon. Companies may also use the new, lower 409A valuation as a recruiting tool, lured prospective employees with cheaper options and the assurance of cashing out at a higher price when the company eventually exits.

Sumukh Sridhara, the head of AngelList's founder products, believes businesses view 409As as an internal equity granting authorization mechanism, rather than them believing they were worthless.

If these corporations could argue that they are worth 5% of what their public market comps are, they would not be able to get away with that, according to the researcher.

Sridhara says that most AngelList startups are skew early, so they believe their stock is useless for them to grant options and equity more efficiently.

An updated internal valuation might indicate that a business is trying to sweeten the deal for future employees and is making moves to recruit.

Sridhara cited the following example: If an employee receives 100,000 shares, it is in the employer's best interests to present the stock to a 409A analyst like it is worth $1 instead of the $10 per share price that venture capital investors may have paid to purchase it. If you can demonstrate that the shares are only worth $50,000 per share, employees will pay less for the exercise, and they receive a little more upside to their capital gains, he added.

According to Swan, companies may also reverse the strike prices they had assigned previously-issued options and revise them. However, many businesses do this because it retains employees as well as attracts new ones.

According to an EquityBee poll from earlier this year, the price of employee stock options is critical, particularly in an environment roiled with inflation, a weak market, and employment volatility.

Sridhara said employees and new hire applicants are extremely sensitive to what the 409A is because it determines how many shares they get. If youre out there in the market, and your valuation is $100 billion, but you can't convincing existing or new employees, you're positioned somewhat differently.

According to Haslett, stock options can have an impact on IT employees who are laid off. Any vested options expire within 90 days of a person departing a company, whether they are voluntary or not. If an employee is forced to exercise their options because the 409A valuation is high, they will likely be charged substantial capital gains taxes.

According to Haslett, some companies will require a 409A appraisal before doing a substantial round of layoffs.

Before you can let all of these people go, you should raise your 409A valuation, which should reduce their tax burden and make it a little less difficult for them, according to Haslett. There are also many other reasons why a company would want a new appraisal.

409As can be updated more frequently, either quarterly or monthly, for later-stage businesses, especially those with a lot of secondary activity.

Note that a company's behaviour doesnt always result in a downpayment of its 409A valuation. Instacart reduced its own valuation in March, but months later, one of the companies' investors reduced its valuation of the company even further. Stripes' internal valuation cut follows Fidelity's reduction of its valuation this year.

Companies that see their 409A valuations decline are still reacting to unknown factors that are affecting their business. Often, they will seek a fresh assessment to ensure that their employees' options are not completely underwater, rather than actively attract new talent.

Is there a trend in Instacart and Stripe?

The next logical question is whether or not more businesses seek a 409A valuation repricing in the wake of the economic downturn. Sridhara said hes seeing more founders turn to AngelList for assistance in reimagining their equity compensation structures.

Because they have so much secondary market activity that their legal team will make them, companies do refreshes, whether they like it or not. You must be informed about your grants.

Cara's VP of valuations told TechCrunch that the number of companies expected to update their expired 409As in May 2022 was 19% lower than expected. In June, that number increased to 24%.

Stripe and Instacart have updated their 409A valuations, but Wilbur did point out that many companies aren't updating their 409A valuations due to the fact that things are so uncertain right now. Also, because these internal evaluations result directly from companies giving options to employees, this lack of desire for 409A assessments may mean that fewer companies are actively hiring.

If one or more of the following are applicable, Carta is advising customers to update their 409A.

According to Carta, most corporations should be reevaluating their 409A valuations unless they are completely heads-down, bootstrapped, or have raised in 2020 and have no desire to raise again soon.

EquityZens Haslett expects that more businesses will seek appraisals in the future, attempting to exploit market prices to pay lower valuations.

Employees, in particular, will [will say] Oh, yeah, this is better for me, Haslett said. I feel like investors, if at first they got some sticker shock by seeing [the lower valuation], theyre going to be like, Oh yeah, if public markets are down 40% or 60% or whatever, it's not that surprising that privately held companies with similar profiles are down that much.

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