How do you value a Startup? How to value a startup with no revenue?
Originally posted here
Understanding 409A Valuations for Startups
Understanding 409A Valuations – an Interview with Ben Straughn, Perkins Coie.
Dave Note: This topic has been very popular and I’ve promoted the topic to its own page.
Dave: Hi Ben thanks for taking the time to do this call with me. For the folks that are going to be reading along, can you take a few minutes here upfront and just give us a little background on who Ben Straughan is, a little bit about Perkins Coie, and then we’ll just kind of roll into the topic of 409A and how to do fair market value?
Ben: Sure, Dave. Thanks for having me participate to talk about myself and Perkins Coie. I’m a partner in the law firm Perkins Coie and my practice focuses on the corporate area of business, and specifically with emerging companies. So I work with high-growth technology, venture and angel-backed companies, including in the areas of digital media, software to service, hardware and related areas.
I often work with boards of directors on issues, including the granting of options and compensating employees. Perkins Coie is a firm that originated in Seattle, but we are actually spread throughout the US, China, and Taiwan. We have offices up and down the West Coast, very much in the technology corridor, and frequently are involved with emerging growth companies that are making option grants and facing other compensation decisions with respect to their executives.
Dave: I know that we’ve had a little conversation on this to start, but let’s start with defining Fair Market Value (FMV), and then we’ll talk 409A in the context of the maturity of the company from start out to more mature companies as they get either towards liquidity, potential IPO, or exit.
Ben: The broadest sense of fair market value is simply, for tax and other purposes, a price at which a willing buyer would pay and a willing seller would sell a given item. So, that really is the nirvana definition of fair market value that we seek when we are trying to value anything, including the fair market value of stock when we’re granting options.
Dave: Let’s start with the startup, or first-time CEO and entrepreneur. What do I need to know about fair market value and this whole issue of 409A?
Ben: This issue comes up poignantly with startups, because it’s very important to grant compensation in the form of stock options, which is a common grant for startups. Here are some basics:
- What are we talking about when we talk about a stock option? A stock option is the right to acquire a share of stock of the startup company at a fixed price for some period of years; generally 10 years. They are very popular with startup companies, because it’s non-cash consideration that lets employees share in the upside of the business. So it really aligns the interests of your executive employment team with the interest of the shareholders in moving things forward and growing the value of the business.
- The exercise price of the option has to be equal to or greater than fair market value of the stock.
- Options are granted at fair market value for business reasons, usually you want employees to share in the upside. In other words, if the company had 1000 shares and each share was worth five dollars, if you just gave someone the shares that would be analogous to an option with no exercise price, right? They can get it now. To have an option, means you have the right to buy a share of stock and it makes sense to use the current value as a way to encourage employees to grow the value of the company beyond that value.
So let’s bring it back to why does it matter so much? It has always mattered for tax reasons – for financial accounting reasons – that option are granted at fair market value. It has been important, but what has happened with the advent of the new set of rules, and pardon my codes here:
- Section 409A (those are the tax laws, the tax codes). Section 409A has made it even more important that an option’s exercise price be set at or above fair market value. What those rules do is they effectively impose a penalty.
- EXAMPLE: We have a company with shares worth five dollars a share, and we want to grant executives the right to buy 10 shares at five dollars a share for some period of time; again, usually 10 years in the future. At the time they exercise, they may recognize income, but not before; the granting of the option did not generate tax for them. That’s another reason options are so popular with emerging companies and their executives. There is no tax from a grant made at fair market value on the executive.
- The PENALTY: What the 409A rules have done is they have increased the cost of failing to grant options at fair market value by saying we are going to immediately tax as deferred compensation. The important thing is the option grant itself creates an immediate tax on the employee who gets a grant for less than fair market value. So, if our stock is worth five dollars a share in my example, and you grant an option to an executive for four dollars a share, you’ve got an immediate tax according to 409A on that grant.
Let’s put aside how that would be calculated and how it would be determined. That’s obviously draconian. It’s a bad result for the employee. It’s also bad for the company that has to withhold and has to report it as wage income for employees or potentially as 1099 income for independent contractors to the IRS, and then failing to withhold and/or report the income to the IRS, you now face potential penalties and interest for failing to make those filings. So you have this result that actually gets worse because then on top of this Congress said, and to show you we really mean it in 409A that we want option grants at fair market value, we are going to impose a penalty effectively at 20% on top of the tax you would otherwise pay. So now you have a tax plus a penalty and it’s an even worse situation. You’ve accelerated gain and you’ve increased the tax rate, so it’s not a good situation.
Dave: For most startups, especially early startups, they may not have heard of a 409A because they are just working on launching their idea. So it’s a big “Aha”; lots of downsides and a number of concerns. Let’s look at the timeline if you’re a startup, if you were counsel to this new startup; what would you tell them to be aware of first, and then we’ll kind of look at it as the company grows. How do they do it?
Ben: Let’s start with Safe Harbor. There are a couple of safe harbors, but the most applicable and useful one is the company that really wants to reduce their risk. They didn’t value options right, because we’re talking about startups and pre-revenue companies. Who knows what the shares are worth?
- So the company that really wants to reduce that risk will go and pay an appraiser to create an appraisal. It would be a qualified appraiser and you would definitely want to use someone reputable who understands startups in the industry, and then you can use their appraisal as a Safe Harbor. It is presumed that valuation is correct
That’s obviously expensive and time-consuming. So to answer your question, do we tell our start-up clients they have to do this? No. We do say that if you want to be most confident, you have to avoid the problem. This valuation is the way to go, because closely held companies have no public stock market. You really do need to get some kind of valuation to be relatively sure you are safe.
Having said that most startups, early-stage companies, the least of their problems is trying to figure out what the value of their stock is, the greater part of their problem is creating any value for the shares. So we can say it is relatively rare for a newly formed company to engage in a valuation to support the fair market value. Most startups will simply use their best efforts to determine what the valuation should be, and go ahead and use that for their option grant. As a business matter, that’s a fairly reasonable approach to take, in my view. It doesn’t solve the legal risk, but it is a reasonable business decision in most cases.
Dave: Then the company grows. Let’s say the company is getting traction and they are getting revenue, and they are starting to build the valuation. When does it become time to say “Guys, should we do a fair market value by a valuation firm or not?” Should id be done annually when you have the cash to do it? What happens quarterly between those things where the company is issuing stock options? The valuation of the company may or may not have changed. What is your recommendation to those companies in between times if they do an annual valuation?
Ben: So the issue is, there is an initial correct fair market value for the stock, and the problem with that precisely describing, is that whenever a company makes an option grant the board must determine fair market value of the stock.
- It’s necessary to make that determination and therefore set the option price. If facts have changed and the value has gone up, you can’t simply say, “well there was a prior valuation and therefore this is the right value.” Many companies will, and can, rely on the safe harbor in simply re-examining the valuation. So let’s say in January you get a valuation and you make a grant. The next quarter you’re going to make another grant. First valuation firms will do some kind of quarterly bring down at a lower cost. It’s also possible and very frequent that we see our boards simply look to that initial valuation, determine if facts have changed, or if there’s something that would impact the valuation of the company differently. If not, then in my example, if you make the next grant on April 1st, effectively re-confirming that valuation because you’ve determined that nothing has changed, and move forward. That’s an effective way to address the 409A valuation matters.
Dave: So for a company who’s status has stayed kind of the same. The business is a bit static or hasn’t seen significant increase in revenues. Do they need to go out the next year and do a commercial valuation?
Ben: Yes, these valuations, if they fit within the safe harbor, they get done on an annual basis.
Dave: You mentioned the role of a board. Is it important here to have a board as part of the process, or can the executive team do it?
Ben: The issue is how do you set the valuation? The answer is, it should be the duty of the board. So we’re talking about corporations, not limited liability companies and that’s really where these issues arise. Those companies have a board of directors, and it is generally the director’s job to do things around the issuance of shares or grants of equity, including options. So it is critical, and we always recommend, that the board, not the president, not the CFO, and not even a committee of the board, make the valuation determination for fair market value of the grant.
Dave: So for early-stage companies that just have a board of advisors, it’s not enough in this case if you are issuing options. It’s probably something that you would recommend.
Ben: Yeah, a board of advisors would not be enough. Even a newly formed company has a board of directors; it may have only one director. If it does have one director, that director needs to make the determination. Now, that director could consult with advisors, including a board of advisors, the accounting firm, or accountants helping the company out. Certainly, those would be relevant checkpoints for the director to check with in making the determination, but the determination should be the director’s at the end of the day.
Dave: So what are exceptions to this? This is an area that is commonly misunderstood. There are a lot of concerns on the startup perspective. Often they have lots of misunderstandings about it. What are other areas that we should know about going into this?
Ben: There are a couple of different exemptions under 409A, and I would definitely guide you to lean on tax counsel on this. Certainly, I started as a tax lawyer, but here at Perkins I would rely on some of our tax professionals to put this in place. A couple of exemptions that I can think of:
- There are maybe three very relevant ones for corporations. One is the restricted stock grant. So we’ll talk about relevant exemptions and then one that really isn’t in my mind.
The exemptions are restricted stock grants, because what that means is, if you grant shares in the company – so go back to my example – you could give that executive an option to buy the shares for five dollars for some set number of years in the future. You can also just grant the shares as compensation. The executive could pay for the shares, you could grant them out right, you could pay a bargain purchase price, and any of those things wouldn’t matter. For 409A purposes, you are not going to run into the deferred compensation rules because the grant itself is outside 409A.
Now, having said that, if you gave that executive a share worth five dollars he or she will have five dollars of taxable income; the company has a tax reporting obligation. So you still need to determine the fair market value, and you’ve got a tax headache upfront to begin with. Alternatively, if you, for example, have them pay five dollars, then they wouldn’t have income at that point. Of course, they’ve got a cash out-of-pocket obligation and it’s fixed at the point that you gave them the shares. So what does that mean? It means if you actually grant stock, you are avoiding 409A, but not some other real economic issues and tax issues around making that grant.
The second exemption is if somebody commonly provides services in the area as a contractor across a lot of firms, or a lot of other companies. So they are essentially an independent contractor; a law firm comes to mind. They would provide the same and similar services across other companies. We generally can exempt those grants from 409A as well. There are devils in the details, and again, it’s always important to get tax help, but at least that is a potential avenue for avoiding 409A. You are making a grant to someone who provides services of this nature to other companies as well. So it’s going to be a contractor almost by definition, right? Those grants can fall outside of 409A.
The third exception to 409A for option grants is: you can actually put in place a plan that only permits option exercises on certain events, including sale of the company and the like. If you carefully construct that plan, and the option doesn’t vest under normal circumstances, but just a departure from the company, sale of the company and the like, you can avoid 409A. So that is sometimes a possibility.
Finally, I mention incentive stock options. Technically not subject to 409A, but keep in mind since incentive stock options must be granted at fair market value that is self-defining exclusion. If you don’t hit fair market value, calling it an “incentive stock option” doesn’t matter. You didn’t grant an incentive stock option, and therefore, you do have a 409A issue. [NOTE: Correct]
Dave: So one last topic, we’re at a point where that employee has elected to leave, or they are being terminated. How do we deal with the 409A as it relates to that, because that’s an incident that is going to create timing issues? So, how do you deal with terminations and departures?
Ben: So now somebody is ready to exercise. How do I deal with 409A? Well, the answer is 409A doesn’t matter here. Not to be too cute Dave, but it doesn’t matter at all because you made an appropriate grant, I’m assuming, and there was no problem with 409A.
- However, there is still a valuation issue when you have somebody exercising their option. You need to set a value for the shares that they received, and we’re assuming the company is closely held and there are no good comparables for the valuation. So you are, at that point, forced to make the valuation decision that puts you in the same box for using that value. Almost certainly, you will of course have to use it across other grants, other transactions in equity, including the granting of options at that time. So it’s important to get the value right if you’re cashing someone out. If you have a 409A value set with which you have comfort then you could use that value, but then why am I talking about the value at all? When someone exercises an option they are potentially going to pay tax and the company must report it as what is gained or the difference between their exercise price – five dollars a share in my example – and let’s say the executive left when that share was worth eight dollars and he exercised an option to buy one share. He would have three dollars of income. So you have the value of five dollars when you granted him the option and you have the value of eight dollars when he exercised, and that income is going to arise and the company has to account to it. So it definitely has fair market value and, therefore, 409A valuation issues, and implications for other grants.
Dave: So last, but definitely not least, how do people get a hold of you if they have questions?
Ben: Thank you, I appreciate that. There are a couple of good ways. You can always call me on my direct line at 206-359-3333, and I can send you a link to our website: www.perkinscoie.com. You can find me under professionals: my name is Straughan
Dave: Thanks Ben, I appreciate the time.
Ben: Thank you Dave.