Don Dodge wrote about a very dry but critically important issue facing private companies that issue equity to employees… 409A valuations:
IPO bump? – If private investors have already bid up the valuation, will there be an IPO jump in the stock price? Doubtful. This breaks the conventional wisdom about pre-IPO stock options. Companies are required to price their employee stock options close to the “market valuation”. It is called the 409A Valuation requirement from the IRS.
We are in a really interesting period where tech IPOs are few and far between and the effect has been for a secondary market to develop for employees of high growth companies to tap into in order to realize actual value from their stock options. This isn’t shocking or new, investment banks have schemed with stock option holders for years and there is nothing wrong with this practice, legal or otherwise.
You may recall that back in the 1999-2001 timeframe it was popular practice for option holders who were in a lock-up period following an IPO to use a short process to borrow their company’s stock from other investors and sell it with the promise that they would forfeit their locked up stock when the lock up expired. Good deal for employees and a good deal for investors. The secondary market that has emerged in our current period is simply a response to market conditions that frustrate liquidity.
The big change between then and now is that the Federal government in it’s infinite wisdom has created an encyclopedia of processes under the rubric of transparency and fairness that ultimately ends up being neither transparent nor fair. 409A is just one of those processes and I agree with Don (and Brad before him) that this will have dramatic consequences for private companies aspiring to tap the public markets.
I say 409A isn’t fair or transparent and the reason it is not fair is precisely because it isn’t transparent… in order to get a 409A valuation you have to hire someone else to do it and as any private equity investor will tell you, valuing a company is more art than science. The unfairness of 409A is a result of the costs, real and opportunity, that it imposes on a company because these valuations always come in much higher than expected and the negotiated valuation still ends up depriving wealth opportunity for new employees who find their newly acquired options much less attractive financially and from an AMT standpoint.
(Cross-posted @ Venture Chronicles)