Rule 409A

I just ran into a Rule 409A question the other day, and the CEO with whom I was discussing the issue suggested I write about it.  So, here goes.

In “VC world” Rule 409A is best known for providing a safe harbor for private company valuations, and in particular the setting of strike prices for employee stock options.  If the strike price is at or above fair market value (FMV), then the grant of the option is not a taxable event as the employee is getting nothing of immediate value.  If the company conducts an outside independent valuation, then, under 409A, the burden is on the IRS to prove that the valuation was not reasonable (i.e., too low in value thereby imparting immediate taxable value to the optionee).  This safe harbor has resulted in companies spending (or, depending on your perspective, wasting) money on getting these outside independent valuations.  A whole cottage industry popped up, and the cost of a valuation is typically $4-8K.   And the company will typically get it updated yearly.

My view is that 409A is a terrible piece of legislation as applied to private companies.  I just read Jason Mendelson’s post from today and he obviously agrees.  I encourage you to read his post.

Here is one reason why 409A valuations drive people nuts.  Let’s say a given company has raised $15mm in VC funding and is generating about $3mm in revenue and starting to ramp up quickly.  Furthermore, it is in an industry where M&A transactions typically happen in the 3-4X revenue range.  That means, assuming a 1X liquidation preference, that the common stock should be worth zero NOW simply based on the fact that the aggregate liquidation preference exceeds the M&A revenue multiples.  Yet, if you get a 409A valuation done, I can almost guaranty that based on alternative valuation techniques (DCFs off projected earnings), the common stock will not be worth zero.  But heck, cannot we just call the value a penny per share and let the government collect more tax when the stock is later sold generating higher gains for the option holder?  That is Jason’s point.

I recently chatted with a lawyer for the same company as the CEO referenced above.  Here is what he told me:  the board can set the stock option price and not rely on the 409A valuation safe harbor.  But, in that case, the burden falls on the company/board to prove the reasonableness of the valuation if challenged by the IRS.  My reaction to this is “fine”.  That is risk worth taking perhaps particularly if you use the aggregate liquidation preference analysis mentioned above. Tough to argue that it is not reasonable.

Worth some thought and discussion.

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