What should I do if my 409A valuation is too high?
If you’re a startup issuing equity compensation (Options/NQSO/ISO), you’ll need a 409A for startup purposes. Get started now at [ Ссылка ]
- There is a very systemic problem in the startup world with valuations coming in too high, and the reason for that is 409A providers are heavily scrutinized by two groups. The valuation accreditation entities that really audit, and look at their stuff, and make sure they're doing everything in compliance, and then the IRS. The IRS really wants these valuations to be fair, AKA, not too low because if they're too low, a bigger percentage of the taxes come as capital gains taxes, which have a lower tax rate, so the IRS wants these to be accurate.
In the old days, boards just used to get together and just make up a price, and then the IRS said, hey, you got to start doing a 409A valuation for this, so that's where this all came from. Now, it's really frustrating because this pressure from the IRS and accreditation entities ends up pushing the valuation people to be more conservative, and more conservative in valuations means a higher valuation. It means that your company, on paper, even though you probably haven't accomplished a ton yet because you're still a startup, is going to have a much, much higher valuation, and so, that stinks for all the employees out there who have to exercise their stock at much higher valuations, so it's important to be able to talk to your 409A provider, and really work with them, and point out some of the things that makes your startup unique, and your situation not just something like a math equation on paper.
- One of the first things you can do is point out those valuation people, say hey, I know I just closed a round. I know you're using the back solve method, which basically means you're working off of my preferred valuation, but that's a preferred evaluation. The VCs are taking a huge bet on me. They have a huge portfolio of companies, and I'm sure they want us to be successful, but it's not guaranteed, and more important, the VCs have liquidation preference and a bunch of other rights that make their shares way more valuable than my common, so just have that conversation, remind them.
- The second thing you want to do is you want to make sure you give appropriately conservative financials to the valuation folks. One mistake I see all the time is that founders will provide the same financials that they use to woo their venture capitalist and everybody, including the venture capitalists know that those projections are pie in the sky, and are very unlikely to be hit. Not many companies ever hit their projections, and so, you want to give the inside case, the conservative case to the valuation people. If you give financials that say you're going to be doing $100,000,000 in revenue in three years, then you're going to get a really high valuation. Use the conservative. If you can do 10 in three years or 15 in three years, that's more appropriate, and that will be really good.
- The third thing you want to do is make sure you pick your comparable companies intelligently. So if you're picking Microsoft and Google, and you're a hardware company, or don't have a monopoly-like those companies do, your margin structure is going to be way worse than them, and you're going to trade at much lower valuations. Also, if you're comparing your company to the new hot IPO that just went public a couple of months ago, it's trading at 100 times revenue, that's going to hurt your valuation. That's going to make your valuation so much higher than it really should be, so pick your comparable companies appropriately. Be conservative. Throw in some older stage companies that are more mature that aren't going to trade at crazy valuations, assuming they are a good comp, and just walk the valuation provider through that. It's really important. You want to end up somewhere in the 25 to 35% ratio of common to preferred, meaning if preferred is $1, you want common to be somewhere around 25 cents, 30 cents.
- As you're getting to 35 cents on a ratio basis, you're getting up there, and again, it's not really the valuation people's faults. They've kind of built this process that's as robotic as it possibly can so that they can scale, and they're trying two appease to different groups. They're trying to appease the IRS / accreditation firms, and then are also trying to appease your startup, but we all know that the IRS comes first, and so, they're going to be very conservative, so you just need to have that conversation and make sure you're looking out for your employees, so that they don't have to pay a valuation on their common stock, on their options. That's just way too high.
