We’ll skip the entire diatribe about how stupid the 409A process is, the complete bureaucratic waste of time and money it layers onto early-stage companies and the rest of that junk. The unfortunate reality is that because politicians have no understanding of start-ups whatsoever, are generally oblivious to the fact…. oops, sorry, we promised no diatribe….
Anyways – 409A valuations are here to stay, and have been for a long time. They are a fact of life if you are starting a company and hope to turn it into a massive success and the better job you do hewing to the line, having an updated 409A valuation ready at all times and not screwing up the 409A process, the better off you and your employees will be.
Unfortunately, you are likely screwing it up, which wastes time, can cost your new hires significant upside and can screw up M&A and IPO processes, or at least add more complexity to them. Time to change this reality.
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Let’s first provide a quick summary of the 409A valuation process as it REALLY happens at the 409A firms that do them – If you work for one and disagree, prove us wrong and leave a comment….
Winning the business for a 409A valuation is all about being (1) a credible provider and (2) price. Having sufficient credibility that accountants and the SEC will accept your valuation as legit is not a high bar to clear but matters – there are a number of firms above this bar. The next step is price because the reality is that all of these firms do the same thing. THERE IS ZERO STRATEGIC VALUE in the 409A process so you should select a ‘legit’ provider who has a reputation for providing reasonable (even conservative) valuations, makes the process easy for its clients and charges the least.
The ONLY thing that matters in the impressively long 60+ page report the 409A firm will (mostly auto-)generate for you is the price per share of the common stock, which will set the floor for the option strike price you can use when granting options. The lower the price, the more value for your employees (with ZERO impact to you or your investors – if you think the lower proceeds from options exercise that result are a negative you are in the wrong line of work). All you want is the lowest possible price per share “within reason”. Period.
Screw it up and get too high a price on your 409a and you might find recruiting is harder (especially for senior execs who understand the importance of strike price), and as a result might have to give up more equity or cash compensation to make up for this.
So there is a good reason to not screw this up. And it only takes a few easy steps.
STEP ONE: Get in the right frame of mind.
Let’s assume you just raised your first round of venture capital and are told you need to get a 409A valuation. You’re coming out of a challenging and stressful process where you successfully pitched the awesome potential of your company and presented mind blowing financial projections that your new investors likely discounted in their minds but signed on for nonetheless. Congrats!! That’s awesome and you are probably feeling really good about your ability to pitch the vision for the business and get people excited about where things are headed.
This happens to be the EXACT OPPOSITE approach you should take with the firm doing your 409A valuation.
Remember, your goal in the 409A valuation process should be to get the firm to return the LOWEST POSSIBLE VALUATION on your business that is “within reason” (rule of thumb at Seed or Series A – shoot for a price per share that is 5-10x lower than the financing you just closed). Do not try to impress the 409A firm with your awesome potential and DO NOT use the projections you just got your investors to buy into. When dealing with a 409A firm you want to be as conservative as possible and to focus on the many reasons your company could fail to hit its marks. Humble, conservative and contrite.
STEP TWO: Financial Model.
Build a new model for the 409A process that provides a scenario which may not be worst case (worst case is you never sell a thing), but recognizes the reality of how hard it is to rapidly scale a company. Lower growth rates, higher burn rates and faster time to out of cash are the keys here. Growing at 2x year over year or less is a very realistic result for your company. Not at all what you PLAN to do, but it could happen, so assume it will when dealing with your 409A firm. If they ask for your funding pitch tell them this is confidential to the company and not something you will share with them in total. Then cherry pick some pages and send these across along with your new model.
STEP THREE: Answering questions.
There are a few things the 409A firm will ask about aside from financial projections and the details of your financing round. These will include expected time to liquidity, business risks and very possibly which public companies you consider to be comparable to yours.
Share all the reasons you might manage to fail and how hard it will be to overcome this. When they ask about expected time to exit and likely exit path you should assume there is no way you’ll scale to be a public company and that while a company might buy you someday you cannot see how that would be possible for at least the next 5-7 years. Don’t forget to mention you’ll also need to raise a lot more capital to even get to that point.
In general, for any question they ask, accentuate the negative (or at least the neutral). Also – if they ask you for comparable public companies give them a list of the ones with the LOWEST revenue multiples and avoid high fliers – they’ll add those in anyways, no need to help them with that effort.
STEP FOUR: Time.
Be annoyed with the time you are spending on this process. Legitimately annoyed because it really is a stupid thing to have to spend time on (We miss the days when the board could just peg the strike price at 1/10th of the latest round price and move on). The 409A process is really simple for the 409A firm and is really boring so they’ll want to talk with you as much as possible because that is the only fun part of the process for the people doing the work. Don’t spend more time on this than you need to.
STEP FIVE: The “Draft” Report.
The firm will send over a draft/preliminary report and is expecting you to come back with edits and issues you want them to address. Plan on this as there is almost always some wiggle room. A few things in particular to consider pushing back on depending on which valuation methods they gave the greatest weight to for the valuation:
Comparable Companies: Scan the list of comparable public companies they used and pick a few with absurdly high multiples and tell them to take those off because they are totally not relevant to you business (even if they are). This will help lower the revenue (or ARR, or …….) multiple they apply to your company which will lower the valuation.
Time to Liquidity: No matter how many years they assumed for this tell them it is way too short and that it should be longer. This will help when it comes to pushing back on….
Discount for Lack of Marketability (DLOM): The firm will discount your valuation because you are a private company and your stock is not freely tradeable. The higher the discount applied the lower the valuation so no matter what they use for this discount (it is shown as a %), push for it to be higher. A longer time to liquidity will naturally lead to a high DLOM percentage.
Valuation Methods: DO NOT WASTE YOUR TIME READING THIS SECTION UNTIL YOU SEE THE DRAFT REPORT AND KNOW WHICH METHODS YOUR 409A FIRM FOCUSED ON……
The 409A firm will do multiple valuation analyses using different methods and then generally rely on one or a couple as the primary methods for the analysis of your business.
These valuation methods will include some combination of Market Approach (Company Transaction Method, Public Company Method and Subject Company Method), Hybrid option pricing (OPM), Market adjustment to equity value, Current Value Method and DLOM, Income approach and Asset approach. It might also include an acquisition analysis and maybe others we’ve missed.
For all of the folloing scenarios, some of the key factors in the prior steps come into play (time to liquidity, financial model, comparable companies and risks to the business). These are going to be fairly universal. Make sure you share your draft report with your board of directors, or at least directors you think are most up-to-speed and savvy about this sort of thing to get their input. You’ll know they read the report and know what they are doing if they complain the price per share is too high and give some input on ways to knock it down a bit.
And NO MATTER WHAT – Push back on the initial draft but do it once you have put together all of the cogent arguments from this post and your board. Go back to the 409a firm with a clear set of arguments that relate to the valuation methods they chose as being relevant, you not unlikely to convince them to use different methods as the key drivers, so focus on the ones they used (see below).
The valuation methods your 409A firm focuses on will be situationally dependent:
If you actually did just close a financing round then the focus will be on that financing round so they’ll use the Current Value Method and Option Pricing Method. For growth stage companies they’ll also lean more on exit potential. For Seed/A companies it will mainly be based on the round you just closed, including the terms for liquidation preference and the like.
If you are doing a one year refresh of the 409A and have not raised a round since the last valuation report they’ll have to do more real work as they’ll rely on your financial results and forward looking model, comparable public companies and the like. You’ll see the term PWERM (Probability Weighted Expected Return Model).
If you are getting a new 409A in the middle of a M&A process (Whoops!) they’ll focus on this and it may really screw up your ability to issue shares that are not very close to the exit value, especially if you have a LOI in hand. BIG MISTAKE to be in this situation and we’ll have a post on this specific situation soon.
If you are a growth stage company doing a 409a refresh they’ll focus more on public comparables and your most recent financing round and time to liquidity will play a much more significant role in setting the valuation, as will liquidated preferences and preferred share rights. Note: At the growth stage you should seriously consider doing a 409a refresh more than once per year – at least every six months and maybe even quarterly. This will be especially true if you are approaching an IPO but also can be valuable if an M&A opportunity arises. Whatever you do at this stage, DO NOT EVER let your 409a valuation lapse!
Let’s also knock a few of these out that will be included by almost never used:
Asset Approach: Will never be used as it looks at the replacement value of tangible assets and your company has VERY few of these.
Income Approach: This method uses discounted cash flows and your model will not have any cash flows, at least not positive ones. If it does, change your model.
STEP SIX: The final report
Don’t waste more time trying to fight for another penny or two in this process. It eventually becomes a rounding error and you have better things to do with your time. As soon as you have your final report you should send it to your board for approval, make it clear this is the FINAL report (no more comments, they had that chance earlier when you sent around the draft report) and propose the option strike price you plan to use going forward based on the price per common share in this report. We recommend getting this approved as soon as you have the report but it is common to wait until the next board meeting when you have new grants to approve. The reason we like to do it immediately (via a UWC – Unanimous Written Consent – can be done via email), is that it puts a valid strike price in place in case you need to grant options quickly (key new hire who wants to know their options have been approved before the next BoD, any whiff of M&A interest, unsolicited proposal for a new financing round, etc). Also saves time in the board meeting and in pre-board prep as your board members can review the report another time and focus on the pre-meeting materials that really matter in their board meeting prep time.
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KPMG has a good article on the valuation methods, just make sure to ignore the reasons they give for getting this work done – Remember – there is no strategic value in your 409a process, it is just a bureaucratic process put in place after so many venture backed companies blew up in the public markets in 2000 and 2001 and somehow this got blamed on stock option pricing. The reality is that the IRS should have cared a lot about this but it did not harm public investors. Letting stupid companies like pets.com and a bunch of other companies that lacked any sort of sustainable business model go public is what harmed public investors. Not that we have an opinion on the subject….
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Note on 409A Firms: To be clear, I think the 409A requirement is an absurd one for early-stage companies but since it is a reality the firms that provide these are a necessity. I have no issues with the firms doing this work and actually think their highly automated approach where most of the report is auto-generated or from a template makes sense, especially as the pricing for this work has thankfully plummeted. Please just recognize that your analysis is not actually a gold standard for anything and the better job you do of accurately reflecting the high risk that early stage companies face the better job you are doing for them. With all that said we appreciate you for being there for companies, even if we all wish it was not required.
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