In a detailed Q&A session, co-founders of intio, Dave Pezeshki and Alex Beard, share their expertise by answering the most commonly asked questions about 409A valuations.
In a detailed Q&A session, co-founders of intio, Dave Pezeshki and Alex Beard, share their expertise by answering the most commonly asked questions about 409A valuations.
Alex: In the context of what our clients are or what they're trying to achieve, private company valuation is extremely important because it directly affects their ability to hire talent and grow the company. With early-stage companies, a large part of compensation is equity-based compensation or non-cash compensation.
So the value at which their company and their equity compensation is extremely important in order to be able to bring employees on board.
Dave: In addition to that, as companies look at the landscape of trying to compete with larger companies, which have a much larger cash component of equity, their best shot is to try to give their employees the maximum upside by giving them the lowest price equity they can give them.
And that's why companies are so interested in what the value of their company is. There are also other uses for private company valuations, but this is within the specific context of the 409A.
Dave: Any company that issues stock-based compensation. It was set up by the IRS in 2007 because of what was happening at that time, public companies were issuing below fair market value options to their CEOs and C-suite executives, and they were getting a sort of tax advantage compensation rather than just getting W2 income. The IRS decided that couldn't continue, so they enforced a regulation called Section 409A for every company that issues stock-based compensation and ensures they do it at fair market value on the date of grant.
When they wrote the law, it netted every company that gives equity compensation, not just public companies. So everyone's subject to the same rules.
Alex: Essentially, the IRS doesn't want companies giving artificial upside to people.
Alex: It's pretty simple. It's going to be required at the sooner of one year after or the occurrence of a material event. A material event is most simply defined as an event that would significantly impact the company and its operations.
So examples would be fundraisings, a change in business plan, a change in the C-suite or management team, or anything that you could argue would materially affect the company's operations, good or bad.
Dave: As soon as you raise a substantial amount of funding, which I would say is somewhere between $250,000 to $500,000. Effectively now you start thinking about, “How do I value the stock option trying to get my employees?” Right? So it's raising money and giving out equity stock-based compensation to people. After that point, it's usually once a year to refresh it to make sure it's not stale.
But if there's a material event, and the material event is a financing change in the equity structure, a significant change in operations, those types of things would necessitate looking at the valuation again to see if the price is going up or down.
Alex: The consequences for the startup itself in the moment are minimal, but from a legal perspective, there are downstream effects and you’ll likely have issues with auditors. However, the primary consequences get levied on the equity holder. If you issue options that are not 409A compliant, they get penalized down the road and then come back and sue you for that kind of stuff.
There are a lot of downstream consequences to not doing a 409A and not issuing your equity comp at fair market value. So those are the two main issues.
Dave: I think for a founder, if you're planning on trying to build a business, it's really about making sure your company looks the part.
So usually a startup will be incorporated. Most startups are incorporated in Delaware. When investors look at the company, they expect to see some level of corporate governance where they have a board, the board makes decisions, and within that framework, they’ll ask, “If you have employees that have equity compensation, how did you value those shares?”
So it's more of a hygiene issue—making sure all the corporate governance is proper because it's the first flag an investor could see if a company doesn’t know what they’re doing. So for a founder, it makes you and your company look less professional. If you want to become a venture-backed startup, you have to start looking like a venture-backed startup.
Alex: I think the biggest difference is that initio Software is created by valuation experts. We focus on one specific thing and we’re not trying to cross-sell services. So when you look at Carta, Pulley, or another cap table provider, they've got a smorgasbord of different services and offerings. They try to be a jack of all trades, but a master of none, with the exception of CapTable—maybe. It calls into question why you should trust a provider with a service that isn’t their core product or area of expertise. And since it’s not their core product, they’ll often do what’s best for them. This can include over-pricing shares to reduce compliance risk. They aren’t worried about it because you and your employees are the ones to suffer the consequences. At initio, we relied on our sheer experience in valuation to create a true software-based product that gives our clients great outcomes fast, all while keeping things cost-effective.
Speaking of prices, another thing that comes up with clients is that some Cap Table providers say their 409A valuations are free. You may think that’s true, but if you are like a customer I talked with the other day, it’s not free. He paid $10,000 a year for a Cap Table with less than 50 stakeholders. For that little activity, $10,000 doesn’t make sense. It’s egregious, but he justified it by saying his 409A was free. Not only is he getting a sub-par valuation, he IS paying for it, he just doesn’t realize it. There’s no free lunch and clients definitely pay a price—a price that you may not realize until down the road when it’s too late to fix.
Dave: Initio is built for purpose.
Alex: Exactly. It doesn't add any significant overhead time over what you're doing on cap table management because the process is so fast and easy—around 15 minutes or less to onboard and provide us with your information and documents, which is essentially unheard of for this type of process. So there are a lot of positives and value-adds to the process itself.
The 409A valuation is necessary for startups to ensure compliance, demonstrate professionalism to investors, and attract and retain top talent. Approaching the valuation process can be intimidating, but it doesn't have to be. Learn more about initio’s fast, reliable, and affordable 409A valuation software by scheduling a demo with us today.
