When you’ve founded a company and are raising funds, if you want to impress investors and close the financing quickly and on agreed-upon terms, make sure that your corporate records are careful, complete and correct. The typical list includes:
- Board and stockholder minutes
- Equity issuance documents
- Contracts with third parties
- Intellectual property filings
- Corporate filings, such as charters and qualifications to do business
- Tax returns
- Records relating to litigation
- Option notices of grant and exercise documents, including valid 409 valuations for past option issuances
Records that institutional investors, angel groups or other investors who are represented by savvy counsel will focus on include records showing that all options were issued at exercise prices not less than the fair market value (FMV) of the underlying stock on the date of grant. They will want to see FMV valuations prepared in compliance with Section 409A of the Internal Revenue Code, which governs taxation of certain deferred compensation, and related IRS requirements.
Keep in mind that the FMV from a 409A valuation is very different in nature, kind, purpose and result than your VC’s post-money valuation of the company. This latter value is typically set so that the investor can infer how much of the company they want to own after their investment, and using this value to set a strike price for options can highly prejudice your option holders. A 409A valuation is typically used for a limited set of purposes, namely issuing options to employees or advisors. They are sometimes used to value restricted stock [along with an 83(b) election] issued to stakeholders in the company who need to pay tax immediately.
We often see investors and their counsel focus on option paperwork only shortly before a target closing date. If they discover that valuations were not properly done, investors may delay the closing and require a restructuring of deal terms in their favor. Here’s how to avoid those problems.
Why Investors Care About Section 409A and Valuations
Investors may not want to invest in companies with unknown liabilities and dissatisfied personnel. If you cannot provide properly-documented valuations, sufficient to withstand an IRS audit, that show that exercise prices of granted options are at least equal to the FMV of the underlying stock, then both option recipients and your company may be at risk for adverse and potentially large tax consequences, regardless of reactions by investors. It is essential to have a proper valuation in place to support every option grant.
Valuations may be obtained both internally, as long as IRS requirements are met, and externally, and they are valid as long as permitted by IRS requirements, as described below. Whether or not investors will accept your valuation is largely based on whether or not the valuation meets those requirements.
When Investors Accept Internally-Prepared Valuations
We often see very early-stage companies prepare valuations internally. If you or someone else in your company has a strong and relevant financial background, preparing a valuation may be possible. The IRS has made the required determination of FMV somewhat vague – “determined by the reasonable application of a reasonable valuation method…evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations” – so your internal expert should have experience in this kind of work and should be aware of the relevant guidelines and standards that have been developed in the area, especially more recent pronouncements made since 2012. However, there are additional IRS restrictions to an internal valuation, such as the following:
- The company must be younger than 10 years old;
- The company must not reasonably anticipate an IPO within 180 days or an acquisition or other change of control within 90 days;
- The preparer must have sufficient knowledge, education and training, as well as experience that generally must include five years of relevant experience in business valuation or appraisal, financial accounting, investment, banking, private equity, secured lending or other comparable experience in preparing a valuation, and it must be reasonable to rely on the preparer’s valuation advice; and
- The stock must not be subject to put or call rights, other than a right of first refusal or repurchase rights on termination of service.
Noncompliance with any of these criteria may trigger an investor and an IRS rejection of the valuation and a requirement that you obtain an externally-prepared one. If you use an internally-prepared valuation, it is a good idea to ensure that your company has directors’ and officers’ insurance and indemnification agreements in order to help protect directors and officers against claims if the valuation is challenged.
When Investors Accept Externally-Prepared Valuations
If your company is not able to obtain or use an internally-prepared valuation, investors and their counsel, and the IRS, will require that you obtain an externally-prepared one, usually by a third-party valuation firm. However, no valuation may be used indefinitely.
Expiration of Valuations
Valuations may be valid until the one-year anniversary of the date with respect to which the valuation was determined. However, if developments after the original valuation date may materially affect FMV, the valuation is valid only until the first of those developments. For example, if your company launches an important product, signs a significant customer contract, obtains an important asset or engages in a financing round, the existing valuation might be invalid.
We often see emerging growth companies wish to issue options shortly before their Series A or other financing rounds close, in the hopes that they can rely on an existing valuation and set a low exercise price. In other cases, towards the latter end of the development cycle, companies seek to issue options prior to a merger or sale of the company, sometimes when after LOI has been received. However, investors and their counsel often view existing valuations as invalid from the time of receiving a term sheet for a financing round, if not before, so if you are seeing to issue options shortly before a closing, either be prepared to get a new valuation to reflect the new facts and circumstances or to obtain a new external valuation after the closing and set the exercise price for those options then, reflecting the upcoming financing. If you promise your employees or other option recipients a low exercise price shortly before a closing but are required to obtain a new and higher FMV valuation, they may be dissatisfied by the higher exercise price that they must pay, so be careful what you promise.
Valuing company stock when in the middle of financing discussions, and particularly after a term sheet or LOI has been received, is a very nuanced exercise and typically one where companies should rely on external expertise to help them navigate these waters. It’s rare that we have seen companies with sufficient internal expertise to handle these situations.
- If companies promise to issue options a few weeks before a closing, the prior valuation is unlikely to be valid. They either need a new valuation, to reflect certain facts and circumstances of “being in financing talks”, or otherwise be required to obtain a 409A valuation post-closing and issue the options post-closing instead.
- If companies document option issuances shortly before a closing, using a 409A valuation that was obtained at least several months before, they are required to obtain a “bring-down” 409A valuation as of that date and redo the option issuance paperwork. Since sometimes the timing does not work to obtain a new 409A valuation before the closing and the exercise price cannot be determined, sometimes companies can simply re-issue the options and provide that the exercise price is the greater of $0.01 per share and the exercise price determined by a 409A valuation as of the issuance date, although obtained in the future.
- If companies issue equity to key personnel but due to mistakes in the documentation have to change the economic terms, resulting in a larger out-of-pocket cost to the personnel, sometimes the companies have to give other compensation to the personnel, in addition to the equity, to placate the personnel. This is always a bad situation because investors don’t want a key person in the company irate at having to pay a lot more for options, compared to what was promised.
To avoid 409A valuation problems and their impact on your company’s financing round, you may wish to:
- Ensure that board approvals and option grant documents are carefully prepared, either by your counsel or internally with your counsel’s review before a financing round begins;
- Ensure that each option grant is supported by a valuation that has not expired;
- Ensure that internally-prepared valuations are used only if all criteria described above are met; and
- When internally-prepared valuations are not acceptable, obtain an externally-prepared valuation and have it updated by the provider at least every 12 months, or earlier if your company’s situation has materially changed.
Please keep in mind that a proper 409A valuation helps provide protection against adverse tax consequences, and if an investor rejects your valuation, it is a sign that the IRS may reject it, too. It is a good idea to obtain the maximum protection possible by obtaining a 409A valuation from a well-regarded independent provider.
For more information about the article contact Chris Edwards at firstname.lastname@example.org.