Sometimes administrative tasks really do matter…
Introduction: In the dynamic landscape of startups, equity compensation is not just a tool for attracting talent but a strategic element in maintaining operational excellence. However, for some reason we fail to grasp, companies often take months between hiring a new employee and getting their options approved by the board.
One common reason for this is they do not have an updated 409a valuation ready to go so these grants get delayed by 1-2 board meetings. Failing to have an updated and valid 409A valuation is relatively simple task and not having this in place serves as a disservice to new hires, who potentially miss out on lower option strike prices. It also reflects poorly on the company’s administrative execution and efficiency. In the fast-paced world of startups such delays can translate into missed opportunities and a demotivated workforce. (for more on getting a 409a done correctly click here for our article on the subject
1. The Importance of Updated 409a Valuations: While annual updates of 409a valuations are the norm, certain situations demand more frequent revisions. These include upcoming events that could significantly increase the company’s valuation, such as new financing rounds or M&A transactions. An outdated valuation in these scenarios can lead to new hires facing a much higher strike price on their options than they had expected. The impact is direct – the more outdated the valuation, the less attractive the options become for potential talent.
2. Strategic Timing for New Financing Rounds and M&A Transactions: Timing is critical when it comes to 409a valuations in the context of new financing rounds and potential M&A interests. For new financing rounds, if there are many grants to make, it’s prudent to complete them while the current 409a valuation is still valid, which usually is no longer the case once a company receives a term sheet that places a new value on the business. In a similar vein the first hint of M&A interest should trigger a swift check of pending grants and immediate board consent at the current valuation because if/when an offer or indication of value comes in, the 409a valuation is no longer valid. Getting all outstanding options approved by your board should precede any negotiations or discussions, ensuring your new hires are getting what you offered them and will be happy with the new round or acquisition instead of disenfranchised by it.
3. Potential Issues with Delayed Action: Failing to update 409a valuations and delay in grant approvals can lead to a range of problems in the event of an M&A. These issues range from non-competitive option grants, dissatisfied new hires and potential legal complexities. Moreover, if the acquisition offer is on the table, the 409a valuation will no longer be valid, and granting options below the acquisition price could result in regulatory and fairness issues that make it virtually impossible to do.
4. Case Studies/Examples: In one case a company being acquired had approved option grants after the letter of intent was received thinking the overall size of the grants would not create an issue. In final diligence the buyer noticed these new grants and due to the tax and other risks associated with a below value grant they had to take on, reduced the purchase price by $15 million, significantly more than the value of these grants. The company tried to address the failing to get the 409a done in time and in this case unfortunately should have just told employees it could not do the grants and structured the transaction so some proceeds went to these employees to make up for the administrative failing.
In another example the company knew it was going to receive a LOI (Letter of Intent) for an acquisition but had not updated their 409a valuation and as a result could not grant options to its new VP for less than the acquisition price, resulting in the executive leaving the company prior to the acquisition which created significant issues with the Buyer that had planned to bring this executive onto its leadership team. Similar to above, when a situation like this arises it is best to be proactive and talk with the impacted employees after putting together a plan to address the issue which may in the case of M&A be a payout from the proceeds and in a new financing round might be addressed by granting more options than had been initially proposed given they are being given at a higher option strike price.
Conclusion: In conclusion, foresight in equity management is crucial in the event of M&A transactions. Staying ahead with timely 409a valuations and option grant approvals is not just a best practice; it’s a critical step in upholding your company’s administrative integrity and ensuring fair treatment of your team. For startups poised on the brink of significant financial events, such proactive measures are not just advisable; they’re essential. Remember that if you have a supportive board of directors, you do not need to hold a formal board meeting to approve option grants and can instead seek a “Unanimous Written Consent” for approvals of a 409a valuation and for option grants (an article on this topic is linked). Ask your legal counsel for help on this if needed, and get it done QUICKLY!!
capgenius.com 