What's a 409A Valuation?

👋 Hi, it’s CJ Gustafson and welcome to Mostly Metrics, my weekly newsletter where I unpack how the world’s best CFOs and business experts use metrics to make better decisions.

Welcome to our May series on Employee Equity.

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:

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:

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.

For startup employees, understanding 409A valuations is essential for two reasons:

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.

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).

There are a few common foot-faults people make when looking at their equity and trying to determine their “paper net worth”.

One of the most misunderstood elements of 409A valuations is the concept of “discounts”.

A discount is the gap between the 409A (what the third party valuation firm said the common stock is worth) and the price per share that was paid during the latest fundraising round for preferred shares (which the venture capitalists determined your company to be worth).

The typical gap is somewhere between 20% and 40%.

But don’t think that the investors are getting hosed by paying more. They are receiving preferred shares, which come with really cool rights, like getting to vote on important things and getting paid first if the company goes under. That’s worth the premium to your common shares, which the 409a is valuing.

As a common shareholder, you WANT a big discount between the 409a and latest valuation round share price. It means that you have a lot of upside baked in. You are essentially “in the money” by the amount between the two share prices.

Another misunderstood element of 409A valuations is the timing of when you exercise your options. Your strike price, what you pay to exercise per share, is determined upon your initial grant. But the taxes you pay upon exercising are based on the gap between your Strike and the latest 409A.

So when you join and receive your grant, your strike may be $1.00 and the 409A is $3.00. But when you exercise, while your strike is still $1.00, the latest 409A is now $5.00. So you will be taxed on the $5.000 - $1.00 delta in this evil thing called Alternative Minimum Tax (aka a rich person tax on people who aren’t rich yet). We’ll cover that in more detail next week. Save your anger until then.

But for now, just know that the 409a when you join is what determines your strike price. And the 409a at the time of exercise determines the ceiling you’ll use to calculate the taxable amount.

(Note: this delta is nothing if your company allows you to Early Exercise - that’s when you buy your shares immediately at the strike price when they’re granted, before they actually vest. It can be risky, as they may not go up in value, but can be a really tax efficient strategy.)

Sometimes when the economy goes down the toilet, the 409A follows. If companies are super employee friendly, they may cancel existing options that are “underwater”, meaning they were issued with a strike price that is now higher than the latest 409a.

Why do this? The options are essentially worthless until they are back above the 409a price, meaning this significant component of employee comp is worth zilch. Not very motivating or morale boosting.

A lower valuation will ease the costs of exercising and also make equity packages more attractive to new hires.

To do this, companies will “cancel” existing option grants and reissue them, with a backdated vesting start period, and a new 409a price. This becomes the employee’s new strike price and new taxable basis for exercising.

It also means they have more upside in the event of a sale. Let’s say a company has a 409A of $2 per share. The market goes south, and they reissue options for $1 per share.

In three years they have a successful outcome and sell the company for the equivalent of $5 per share.

The option cancellation, repricing, and reissue gave the employee the upside of $4 per share upon sale ($5 - $1), vs the original outcome $3 per share ($5 - $2).

The employee, will, however, have to pay taxes on the extra $1 gain per share, but, hey, I’d rather be in the position of getting +$0.75 than nothing on that extra $1.

As an employee, you are entitled to ask what the last 409A valuation came in at. It may also be in your Carta account, depending on what level of visibility the company gives to employees on the portal.

You can also ask if they expect to get a new one done soon. It will be up to you to read the tea leaves as to if the 409A is expected to go up or down. If the market is severely down, like at the end of 2022, you can probably anticipate the 409A going down due to the market comps you are being compared to. If that’s the case, you may want to wait to exercise to lower your tax exposure.

On the other hand, if market conditions are good to neutral, and your company is growing like a weed, it would be a good bet that the 409A will probably go up.

Keep this in mind too if you are thinking of joining a new company. It’s great timing to get in and sign your package right before a funding round goes down, rather than after it, where they will have a fresh new (and higher) 409a. You’ll get in at a lower strike price.

That’s why I’ve always found it funny how companies use funding events as a publicity stunt to hire new employees. Yes, the company now has more cash in the bank, which helps de-risk it going to nothing. But it’s also advertising their upside is now less, since options will be granted at a higher price. But I digress…

Next week, we get right with Uncle Sam!