In a recent blog, we dove into what exactly a Rule 701 disclosure is, and how it can help startup employees evaluate the value of their company’s shares. Similar to a Rule 701 disclosure, a 409A valuation can offer insightful information on your company and the broader market. We often speak with employees who want to better understand what it means for them and their options.
What is a 409A valuation?
The 409A valuation (aka fair market value or FMV) of a company’s common stock is typically established by an independent valuation firm and determines at what price stock options are issued. The 409A valuation also impacts the amount of taxes due on the exercise of stock options and a later sale of the owed shares. A valuation firm creates a detailed 409A report which takes into account the company’s recent financial performance, revenue scale, how similar public companies are valued and overall macroeconomic conditions. Depending on the maturity of a private company, the 409A valuation may be updated yearly, quarterly or monthly, and must be updated after major events such as a financing round. It is important to keep in mind that the 409A valuation reflects the current value of common equity, not preferred equity, which most published valuations are based on. In certain situations, however, the 409A valuation and most recent preferred shares may have the same price since 409A valuations typically track closer to preferred equity valuations as a company gets closer to an IPO.
What might a change in 409A valuation mean for a company?
An increase in 409A valuation can be a positive sign for options holders, and reflect the maturation of a company, potentially providing a clearer path to an exit. On the flip side, a company can proactively cut the 409A valuation to bring it more in line with public comps or to make options/RSUs more attractive to employees. Recent examples of internal valuation cuts include Stripe and Instacart. Despite some seemingly drastic reductions, the 409A valuation may not reflect how well a company is actually doing.
Seeing your company’s common share price decrease is never a good feeling, but in certain situations, it may be an opportunity to message the employees about a disconnect that is occurring or even provide employees an opportunity to more affordably exercise their stock options when bright prospects lie ahead.
What might a change in 409A valuation mean for an employee?
As an employee, seeing a falling 409A valuation can put a damper on morale, but with a shift in perspective, you may come to realize this can actually work to your advantage. The 409A valuation, particularly for mid and late-stage companies, can be heavily influenced by the public markets at the time. Sometimes a decrease can reflect a company’s prospects, but it can also reflect a market environment where comparable public companies have decreased in value. Occasionally, a decrease can reflect a temporary phenomenon, similar to what was experienced in mid-2020 or it can be more akin to the turmoil experienced in 2022, which may be longer lasting. If a company continues to perform well, the 409A valuation will typically rise again over time.
Market fluctuations aside, a lower 409A valuation is generally better from an employee perspective, provided the company continues to perform well. This provides employees an opportunity to exercise options with a lower tax burden. In certain situations, a decreasing 409A valuation can be thought of as a parallel to value investing. A company’s performance might be suffering, or there could be a bear market, but these may be temporal events that provide an opportunity to lower employee taxes at exercise and capture increased upside.
Are you considering exercising your options?
If your company has seen a recent change in 409A valuation, you might be considering exercising your options. At Liquid Stock, our solutions are tailored to meet your specific financial goals and needs. Reach out to our team to connect with your advisors and learn more about the potential benefits of exercising your options now.
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