409A Valuations - Timing and Considerations
Key takeaways
Many factors, including down rounds and declining public company valuations can negatively impact private company 409A valuations
In case of a lower 409A valuation, the board should carefully consider the impact on their employees and the overall equity compensation program, exercising their fiduciary duties and seeking professional advice when evaluating the need for repricing or other actions.
What happens to 409A valuations in a bear market?
Every founder and employee with equity-based compensation should strive for the fair market value of the common stock to consistently rise over time. Although this means that some of the later hires will pay a higher price for the exercise of their options and possibly higher taxes for everyone, subsequent higher 409A valuations are a sign of the company doing well. Conversely, when market conditions generally deteriorate, a bear market can place downward pressure on 409A valuations.
First, if the company is subject to a down-round, this directly influences the fair market value of a company's stock. A down-round refers to a subsequent funding round in which a company raises capital at a lower valuation compared to previous rounds. This qualifies as a material event and therefore, forces the company to obtain a new valuation for the issuance of new stock options. Moreover, it has a direct impact on the financial gains of options granted at the prior valuation, especially if the employees have not exercised it yet. These employees may have an underwater option, as they will have to pay a price for the share that is higher than the fair market value.
Second, even if a company has not suffered a down-round, a decrease in public markets and the risk of an economic downturn also affect 409A valuations, especially for later-stage start-ups that are closer to their IPO. If the valuation relies on comparable companies as the key metric for the analysis, poor performance of the public market will directly affect the valuation. [CS1] Moreover, market downturns can impact the company’s performance which damages any valuation methodology based on discounted cash flow or projected income.
Finally, if the company is performing but takes longer to IPO to avoid the lower valuations offered by the market, eventually the lack of marketability of the share also drives the valuation down. Although it is not crystal clear when any of these factors may single-handedly turn into a material event that forces a new 409A valuation, these market pressures certainly create challenges when justifying prior 409A valuations in front of employees.
When is a 409A valuation required?
To navigate the effects of lower 409A valuations, companies should carefully consider the impact on their employees and the overall equity compensation program. In some cases, companies may need to reassess their equity grant strategies or consider alternative forms of compensation to mitigate the impact of down rounds on employee stock options. Eventually, if the valuation drops significantly, option repricing might be the way to go.
Option repricing refers to the practice of modifying the terms of existing stock options, typically by reducing their exercise price, in order to align them with a company's current market value, and as the reader might expect it is a delicate matter. First, it requires board approval, and investors on the board may not agree for numerous reasons. As with any financial calculation, the 409A valuation stands on certain assumptions of the market and where it’s going that might not be shared by every person reviewing the numbers. Also granting options at a lower strike price while the preferred shares remain at the same price is a tough sell. Second, by issuing more shares at a lower price the company is effectively diluting the total option pool value. Although the repricing is meant to improve the value of the options for employees, if done inappropriately it could end up hurting those meant to help. Finally, if not communicated properly it can erode employees’ trust in the company.
Because of all this, repricing is fairly uncommon, and the general recommendation is to avoid it unless absolutely necessary. The question then becomes, when should a company reprice? Unfortunately, there is no golden rule that can be articulated for this matter, but the board should take into special consideration its fiduciary duties when analyzing the subject. Actions taken, or more importantly not taken, based on advice not tailored for the company can actually expose the board to more litigation. The duty of care requires the board members to seek professional counseling and duly analyze the pros and cons of all the possible action courses. Boards that exercise this level of care get the benefit of the business judgment rule, the legal standard that protects the decisions made by the board without the fear of personal liability for actions that turn out to be unsuccessful or have negative consequences.
Even if repricing is not the right measure, it is essential for companies to carefully evaluate and address the effects of down rounds and market pressures on their 409A valuations and employee equity programs to ensure fairness and compliance with tax regulations. By following best practices related to the 409A valuation, a company preserves the integrity of equity compensation, thereby bolstering efforts in recruitment and employee retention. While an employee generally cannot require a 409A valuation on behalf of the company, as the board is responsible for ensuring compliance with tax laws and establishing the exercise price for stock options, they can certainly express their concerns or raise questions about the valuation process. If this matter is not addressed with the same level of care mentioned above for repricing, it is only a matter of time before employees start exploring other avenues like litigation.
Conclusion
In conclusion, maintaining the integrity of a company's 409A valuation is crucial for the fair and effective management of equity compensation. Moreover, it is important to recognize that 409A valuations are a double-edged sword. While they ensure compliance with tax regulations and provide a benchmark for determining the exercise price of stock options, they are also susceptible to the impacts of down rounds and market pressures.
Companies must navigate the challenges posed by these factors and carefully evaluate their effects on 409A valuations and employee equity programs. Boards should exercise their fiduciary duties and seek professional advice when evaluating the need for repricing or other actions. By doing so, they can make informed decisions, protect the interests of their employees, and maintain a fair and transparent compensation structure. Proactive evaluation and responsible decision-making in this area are essential to strike the right balance and mitigate potential risks associated with 409A valuations or litigation.
Disclaimer
The information provided in this article is for general informational purposes only; it is not investment, financial, legal, or tax advice, nor does it constitute an offer or solicitation for the purchase or sale of any securities or a recommendation for any investment product. The article does not take into account your personal financial situation or investment objectives, and therefore you should not rely on this article. Before making any investment decisions, we strongly recommend that you seek professional financial advice from a qualified advisor who can assess your specific financial situation and provide personalized recommendations. The company disclaims any and all liability for any actions taken based on the information provided in this article.
