Issuing stock options

This is the most popular reason that early-stage companies get a 409A valuation done, bar none. As a private company, you need to know the value of a common share before you can issue any options. This has a massive impact on your company’s strategy as it directly affects your ability to attract and incentivize talent. Because of that, it’s important that you get a 409A that properly reflects your company’s stage and risk factors. As an example, I often see clients bring me thoughtless 409A valuations performed by other providers that vastly overstate their company’s value. Why? There are a whole host of reasons but the most typical is that there is little thought in adjusting academic valuation models to better reflect the risk profile of a young startup.

Issuing founders shares

While not entirely necessary, we often see legal counsel strongly encourage their early-stage clients to have a 409A done when issuing founders shares. This advice typically follows one of the following three situations:

1. The Company is just incorporated with no assets. In this case, it’s more of a risk mitigation exercise to get a de minimis valuation performed as a formal record, affirming that, at its current stage, the company holds nominal value as a newly established entity. 
2. The Company is just incorporated with transferred assets. In this case, you would want to have a valuation expert come in and properly value the Company so that you can get the most optimal outcome when issuing founders shares while retiring the audit risk associated with this situation.
3. The Company has already been incorporated and is adding a co-founder. Often this happens after the Company has made some tangible progress or raised some sort of financing. In this case, the outcomes may be limited by circumstance, so it is important to choose an expert that fully understands the situation and reflects that in the outcome.

Share buyouts / buy-backs

The reality, while not always comfortable, is that founding teams may not remain intact indefinitely. As such, situations may arise where there’s a need to buy back shares from a departing founder or employee. The discussions around these transactions often revolve around determining the fair value of the founder’s shares. Without a foundation for establishing this value, these discussions can become protracted and uncomfortable. While a 409A valuation does not dictate the process, we often see it utilized as the basis of value for such buybacks.

Another common question we get at initio is: how long is a 409A valid for?

Best practice is to issue an updated 409A when there is a material event or at least every 12 months. A material event is any event or occurrence that can impact the company’s stock price. Examples of material events: a new financing, whether equity or debt; major technical breakthroughs or fundamental changes to a business plan; significant changes to key personnel or corporate restructuring; significant changes to financial forecasts, and more. This means that as a founder, CEO, or CFO you need to have your finger on the pulse of the business so that you are aware of any events that may affect your company’s stock price and your ability to grant or repurchase equity awards.

Not only does understanding 409A and its uses make you a better startup leader, but it also ensures that you do not run into any precarious situations involving employee awards. A very relevant example, that we often see, is when clients end up in a situation where a material event has occurred, yet they have not yet granted backlogged options (sometimes for hires as far back as a year). The fundamental issue is that 409A requires that options be issued at fair market value on the day of the grant, not the promise or hire date. This means although you may have promised employees their options when the price was “X”, you would need to grant the options at a price of “Y”. By understanding the uses and limitations of 409A on the front end, getting board approval for the options would be placed towards the top of your priority list.

In conclusion

Navigating the intricacies of 409A valuations is not merely a compliance exercise for founders and early-stage employees; it’s a strategic imperative. The ability to issue stock options, allocate founder shares, or conduct share buyouts with precision hinges on a nuanced understanding of 409A and its practical applications. Too often, companies fall into the trap of relying on thoughtless valuations that fail to capture the true essence of their stage and risk factors, potentially hindering their capacity to attract and incentivize talent.

Whether you’re at the inception stage, transferring assets, or welcoming a new co-founder, the wisdom in obtaining a 409A valuation is apparent. It serves as a safeguard, not only against legal pitfalls but also as a strategic tool to optimize outcomes in complex situations. 

Furthermore, the temporary nature of a 409A valuation underscores the need for vigilant monitoring by founders, CEOs, and CFOs. Material events can swiftly alter the landscape, making it imperative to stay attuned to the pulse of the business. Understanding the expiration triggers of a 409A valuation is not just a regulatory box to check; it is a proactive measure to avoid awkward scenarios where promises made to employees clash with regulatory requirements. By grasping the nuances, limitations, and timelines associated with 409A, startup leaders can not only enhance their decision-making but also safeguard against potential pitfalls, ensuring that their equity-related decisions align seamlessly with the dynamic trajectory of their business.