Striking a balance between investors and employees when having a 409A valuation conducted on a company’s share price is more manageable than many CFOs think, a valuation specialist says.
CFOs walk a fine line when their company is valuing common shares they make available as options to their employees, says Chad Wilbur, vice president of valuation services at Carta and a member of an American Institute of CPAs (AICPA) valuation task force. Carta is a capitalization and valuation software company.
Especially for startups that are competing for talent against bigger rivals, stock options can be a big part of the compensation package they offer. But getting the valuations right can be tricky.
If the shares are valued high relative to the price of preferred stock — something investors tend to like because of the increase to their equity — employees can find it difficult to reach the strike price and sell their shares to access liquidity. If the shares are valued on the low side, the strike price can be attractive to employees but it can act as a negative on investors’ preferred equity value.
Valuation flexibility
409A valuations stem from the 2002 Sarbanes-Oxley law as a way to ensure stock-based and other types of deferred compensation are valued based on a set of principles rather than, as had been done in the past, on softer, more negotiable criteria.
To meet accounting controls, CFOs generally have the valuations conducted once a year. But valuations are required if the company is planning a liquidity event, like a private capital raise or a public offering. Companies often add a secondary financing to a primary raise to make existing shares available for sale. Depending on how the secondary offering is structured, employees can use the sale as an opportunity to trade their shares for income.
Whatever the context, CFOs shouldn’t think they must take a hands-off approach and just let a valuation specialist manage the process, Wilbur said in a webcast. There are levers to pull that can help CFOs strike the right balance on the valuation ratio between preferred and common shares.
“Oftentimes CFOs feel that they just have to accept the result that’s given to them by their advisor groups, whether that’s their valuation provider or their auditor, and I don’t think they fully understand that a lot of the consideration that’s given to the secondary stock transaction is controllable,” he said.
Weighting considerations
As a general matter, the greater the limitations on the secondary offering, the lower the ratio between the preferred and common stock valuations, and thus the more advantageous the strike price is for employees. The fewer the limitations, the higher the valuation ratio.
“The key takeaway is, if you are a company that has raised financing, and you’re completing a secondary stock transaction, you should have a pretty viable range here to determine if the 409A result you’re getting is reasonable,” he said.
The more control the company exerts in a secondary financing over what shares will be included, who can sell, who can buy, what information is provided to buyers and other limitations of that nature, the lower the ratio will tend to be between preferred and common share valuations.
By contrast, the looser the control — with more shares available, more employees who can sell, and a wider range and larger pool of buyers — the higher the ratio between the two stock valuations. Frequency of financings matters, too, with fewer offerings translating into lower ratios, and vice versa.
“That’s both historic transactions and how many do you expect to do in the future?” Wilbur said. “The greater the frequency, the higher the weighting on the secondary value.”
Similarly with information rights. The tighter the available information on the offering, the lower the ratio, and the looser the information available, the higher the ratio.
When the levers are added together, a picture emerges of the kind of offering that can lead to a lower valuation ratio. For example, an offering in which just a select few employees are eligible to sell a limited number of shares, and the buyer pool is restricted, with maybe an anchor buyer who is committed to buying a majority of the shares, and the company doesn’t have a history of frequent offerings, the valuation ratio will tend to be low.
In an analysis Carta conducted on almost 150 secondary financings, the ratio between preferred and common stock was between 30% and 45% for offerings of less than $100 million, and between 31% and 57% for those of more than $100 million.
Valuations that don’t involve a secondary financing but are conducted as an annual check or for a primary financing only, to raise new money, the ratio tends to be lower, but not by a lot.
“There’s not a significant variance for companies that complete a secondary stock transaction versus those that do not,” he said.
Accounting scrutiny
Both the IRS and the Securities and Exchange Commission (SEC) are interested in how reasonable the 409A valuation is, although for different reasons. The IRS wants to make sure the valuation is reasonable for tax purposes, under Sec. 409A of the U.S. Tax Code, from which the valuation gets its name. The rule includes a safe harbor, which protects companies against pushback from the IRS as long as the valuation falls within it.
“I’ve never seen a 409A challenged by the IRS,” Wilbur said. “If you’re under the safe harbor, the IRS has the burden of proof to basically say the valuation is grossly unreasonable, which is very difficult to accomplish.”
The SEC looks at the valuation from an accounting perspective, based on Financial Accounting Standards Board (FASB) rules under ASC 718, which has some important differences with 409A, including on the amount of information investors receive on the offering.
The two rules “have been fairly synonymous with one another, because the definitions are similar, but they don’t have to result in the same conclusion,” Wilbur said. “We’ve never run into an issue where we couldn't resolve the matter. One’s an accounting number and one’s a tax number.”
