Welcome to our May series on Employee Equity.
Part 1: What’s a 409a Valuation (TODAY!)
Part 2: Paying (Avoiding?) Taxes on your Equity (NEXT WEEK!)
Part 3: Getting RICH off Secondary Transactions
It’s crazy - when you enter the startup game there’s no “crash course” on employee equity. We essentially trade four years of our lives for an illiquid bet on a single stock that may make us extraordinarily wealthy. But we fail to understand the basic mechanics of these strange wealth instruments.
Two things I want to say at the start of this series:
Employee equity is NOT too difficult for you to understand. You do NOT have to be a “finance person”. You ARE smart enough.
It’s silly to just PUNT on this stuff because you don’t want to ask the “dumb” questions.
So fear not! I’ll ask (and answer!) them for you.
If you work at a startup but don't understand what a 409A valuation is, you might be leaving money on the table. Let's change that:
What’s a 409A?
A 409A valuation is a report that determines the “fair market value” of a company’s common stock. In other words, people from outside the company come in and value the options you’ve been granted.
It’s named after a really boring US tax code: Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans. If you can’t sleep tonight, carefully thumb over to the section below:
Please, don’t, though. It’s like chewing glass.
Why is a 409A important?
For startup employees, understanding 409A valuations is essential for two reasons:
It determines the strike price for new employee grants.
Companies are not allowed to grant options below the latest 409A price.
It determines the taxable basis for existing employee grants.
When an existing employee exercises (read: buys) their options, they get taxed on the difference between their strike price (which doesn’t change) and the latest 409A (which does change).
How often does the company get a “new” 409A?
Startups are required to have the 409A refreshed, or reassessed, at least 1x per year by a third party. This means you can’t come up with a valuation yourself. That’s no bueno.
As a company, you’re on the 409a treadmill as soon as you raise your first priced round. Before that, you’re off the hook.
Companies are also required to get a new 409A done when something big and important happens, like a fundraising event, or you acquire another company. Basically, you trigger a 409a refresh anytime you do something that fundamentally changes the value of your company.
How are 409A’s calculated?
Don’t attempt to read this section without your shoe laces tied.
409A valuations are based on a variety of factors, including company size, recent financial performance, and industry.
Each time a 409A is performed, the finance department sends the valuation firm (someone like Carta) the latest financials, along with a summary of key events that have occurred since last valuation (like hiring a CFO, acquiring another company, hitting stated board targets etc.)
They also send a list of publicly traded companies they believe should be used as comps. This is the most common way to value a firm. You take a list of 15 to 20 publicly traded companies operating in similar industries (e.g., social media companies get compared to social media companies) and with similar business models (e.g., marketplaces get compared to marketplaces) and check what they are trading at (e.g., multiples of revenue and EBITDA). Then you apply a discount for being illiquid and not as large.
Other common ways to value a company are to do a discounted cash flow analysis, which uses management’s long term operating forecast to figure out how much cash the firm will pump out over the foreseeable future.
And sometimes you can value a company based on M&A transactions in the space, if there have been enough relevant ones over the last 18 months. This is often the most useful, but least available, due to the smaller population size.
At the end of the day, the 409A goes up in value when the company’s revenue is growing. It also goes up when the public comps you are being compared to are doing well (a rising tide lifts all ships!).
And it goes down when your growth or the economy’s growth slows. Those are the general rules of the road.
A higher 409A is a double edged sword - you want your company to do well and be worth more, since you are theoretically now worth more on paper, but it also means you have to pay more taxes upon exercising your ISOs or NSOs (more on that later).
How does a 409A valuation impact my equity?
(Paid readers get access to our employee equity database for benchmarking their own grants)