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HEIDI: Welcome to the Startup Solution and "The Case of the 409a Freak-out." I’m Heidi Roizen from Threshold Ventures.
When you ask an early-stage entrepreneur what a 409a valuation is, they usually say that it’s an official process to determine the value of their common stock.
So, when that 409a valuation goes down, their reaction tends to range from mildly insulted to feeling like they got kicked in the gut – like this entrepreneur I’ll call Alyssa.
. . .
ALYSSA: Hey Heidi, I just got our 409a, and it’s down over twenty percent. I mean, that sucks. I don’t think it takes into account any of our progress over the last year. And I don’t know how employees will react when they hear about this. I really don’t understand why this happened. Any ideas on how I should approach this?
. . .
HEIDI: I’ve seen a lot of falling 409a’s since the market highs of 2021. But does a falling 409a really mean that your company is less valuable now than it was the last time one was calculated?
Lucky for Alyssa, not necessarily – and I’m going to help her understand why. But to set the stage, let’s start with a little history.
When I first became a VC in 1999, there was no official process for valuing common shares. We literally just sort of made it up. I remember there was this rule of thumb that in a company’s very early days, you might value the common at, say, 10% of the preferred share price. Then, as the company grew, you’d move the common up a little each round, not only as the preferred share price rose, but you’d also decrease the delta between common and preferred as the company matured. Eventually, close to IPO time, the goal was to have them merge. And that was kinda it.
On the one hand, even back then, a rising common share price felt like progress. But on the other hand, having a low common share price provided advantages, like lower strike prices on options for our employees, and being able to give out more restricted stock units (or RSUs) for any given dollar value of a grant. So, we weren’t in a big rush to increase the common share value. If anything, we wanted to keep it as low as possible since the benefits of doing that were easy to explain to everyone. Our real sense of value progress came from the preferred share price since it was determined by an actual market and actual buyers – not by us making stuff up.
. . .
But then, the dotcom bust happened. And a few other things blew up around then, too – like Enron. While we can’t blame the tightening of these accounting rules exclusively on Enron, its collapse put a spotlight on certain questionable practices. One of those was that the Enron executives were manipulating their equity incentive plans in order to pay less in taxes than they would have otherwise. You see, if you can arbitrarily manipulate an option’s strike price, and that strike price is part of the equation that determines your taxes, well, you can see where that might end up. And the IRS did not look too kindly on that – so they decided to do something about it.
As part of the Jobs Act of 2004, the IRS Code, known as section 409a, was tightened up. It nailed down when executives could elect to defer compensation, how it would get paid out, over what time period, when it can be accelerated – and how to value the equity involved in that deferred compensation – which is the part we’re talking about today.
. . .
So that’s why we have 409a. But how’s it calculated?
Well, the 409a valuation process involves looking at a number of specifics about a company and the market it operates in.
The accountants hired to do the valuation will look at the company’s financial statements, including the income statement, balance sheet, cash flow, and cash position.
But does a lower cash position than the last time the 409a was done mean the company is worse off? Well, not necessarily.
For example, let’s assume that you raised a round 12 months ago and you don’t plan to raise again for another 18 months. If you’re still in your growth phase, it’s likely that during the past 12 months, you’ve burned through some of that capital to fuel your growth. After all, that’s why you raised it in the first place. But even though you did that by design, less money in the bank is usually a negative drag on a 409a.
. . .
Another thing the accountants will consider is a comparable analysis – that is, how would your company be valued based on how other companies like you are valued. Of course, they usually don’t have access to the financials of other private companies that you may be competing with. Instead, they’ll consider the valuation multiples of publicly traded companies or recently acquired companies in the same space, if that data’s even available. These are imperfect proxies, at best, for your company’s actual value.
The 409a accountants will also look at your recent financing rounds, both the terms and valuation, to provide an external, market-validated number. Personally, I think this is one of the most important variables because it’s an actual market-validated price that someone actually paid to own your stock, albeit your preferred stock, which is not exactly the same as common but still a strong indicator of company value. But 409a’s happen every year, and financing rounds do not, so a recent preferred price is not always available.
. . .
The accountants will also look at your business plans, your revenue and growth projections, and they’ll also do some form of market analysis of your products. They may also do a discounted cash flow analysis of what your business plan says your cash flow will be. As you can probably imagine, for an early-stage startup these things will undoubtedly change as the company grows. And to be blunt, these are also pretty much made-up numbers for an early-stage company.
All these things the accountants will do sound like a lot of work, right? So, you’d think you’d have to pay a lot of money to them to do all that. But actually, if you’re a super early-stage company, you can hire an accountant to do a 409a valuation for less than a thousand dollars. Even for a series A company, you can get a 409a done for about 2,500 bucks.
. . .
So now let me ask you this. You’re paying a licensed professional or professionals to do all that work, and you’re paying them a few thousand dollars at most for the whole shebang. So, how much super-detailed market research, industry research, competitive analysis, and the like do you think they’re actually doing?
My point is that a 409a does not thoroughly examine even the stuff that goes into their calculations – let alone the stuff that really makes your company valuable.
Stuff like the vision and leadership of the founder. The quality of the team. Where you are in your R&D, and the true potential value of your intellectual property. Or whether your product is better than the other startups trying to do the same thing. They don’t determine the potential for you to disrupt a market or create an entirely new one, which, of course, could mean massive future outcomes.
In other words, much of your secret sauce is not even considered in your 409a valuation.
Look, I’m not trying to malign the accounting profession. And I’m certainly not going to attack the IRS either. I’m just saying this process was invented to keep executives from gaming the tax consequences of deferred compensation – not to create a price for what your common shares are really worth should you want to sell them to someone else right now.
. . .
Let’s get back to Alyssa, the entrepreneur who called me about a falling 409a and its impact on employee morale. She asked me to help her understand what a 409a is and how to share the news with her team. So, let’s help her do that.
First of all, she should explain to her team what a 409a valuation is and its purpose – which is primarily to set the exercise price for stock options and the value of RSUs for tax calculation purposes.
Alyssa can tell them the usual inputs that go into this valuation, like financial statements and a cursory market analysis. Since a 409a drop can usually be explained by a few primary data points, Alyssa should ask her accountant to summarize the biggies that affected hers because sometimes it's a bit hard to tell in the resulting report. And she might want to share these with her team, too.
In my experience, one big one is usually public market comparables and multiple compression. For example, let’s say public SaaS companies used to trade at about 10 times revenue, and now they’re trading at about seven times revenue. That will lower the 409a’s of all startups in the SaaS world – regardless of how well or poorly any individual one is doing.
. . .
Another one I’ve often seen is that a shorter runway means a lower valuation, even if it’s shorter because the company chose to put off a fundraise until a milestone that will greatly increase its value has been hit. That is, there’s a strategic reason to not fill the bank account right now, and that’s not actually a weakness.
The point is, demystifying what the drop can be attributed to can be very helpful for employees to understand.
Then, along with explaining what the 409a is based on, Alyssa should emphasize what it is not – it’s not an assessment of their team, their prospects, or their competitive position with respect to other startups. Nor an assessment of their chance to disrupt the industry they’re aiming at. All that makes up the magic – and the future potential – of their startup.
Finally, Alyssa should remind them that a 409a drop is like putting a discount tag on something you really wanted to buy anyway. You’re still going to get it, but now you get it at a lower price.
. . .
So, what can you learn from the Case of the 409a Freak-out?
First, a 409a valuation is primarily designed to set the exercise price of stock options and RSUs for tax purposes – it’s not a true market-based assessment of the company’s overall worth or potential.
Second, several factors can influence a 409a valuation, such as public market comparables or the company’s runway, which are not perfect proxies for determining the true value that these shares may ultimately have.
And third, there’s a whole bunch of stuff your company may have going for it that will not be reflected in the 409a, including leadership, team quality, or disruptive potential.
And in my experience, it’s all that secret sauce that turns your company into a winner, not the stuff that’s measured in your 409a.
. . .
HEIDI: And that concludes "The Case of the 409a Freak-out." For the record, this situation is real, but Alyssa is a composite. And no startups were harmed in the making of this podcast.
Thanks for listening to “The Startup Solution.” We hope you’ve enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.
Carta provides a pretty comprehensive discussion of 409a’s here.
While we all think of 409a’s in the context of getting a valuation for common shares, it stems from The Internal Revenue Code, section 409a. A little ‘fun’ (if you think of the Enron bankruptcy as fun) history here.
