My Big Rethink Part 4: Responsible Maintenance of 409a Valuations

This is the fourth in a series of posts related to rethinking governance and compensation practices at venture-backed technology companies. My perspective is formed by 35+ years of running and investing in these types of projects where I have helped create wealth for investors, founders, and employees. Previously, I have written on the importance of protecting employee representation on boards , ensuring fairness around secondary stock sales by employees, and revising how we handle employee option exercise policies . Here I want to discuss a somewhat boring but really important topic: responsible management of a company’s 409a valuation.

In my previous post on option exercise periods, I touched on the significance of 409a valuations . A 409A valuation is an appraisal of the fair market value (FMV) of the common stock of a private company by an independent third party. It is important to remember that, except in certain situations related to secondary sales of private stock, shares of a private company are mostly illiquid. And in most all cases, both the timing of liquidity and the ultimate liquid value of the stock is highly uncertain.?So why should employees care about this particular subsection of the 60,000 page US tax code?

Let me start by saying that I am an enormous believer in equity option compensation for employees in venture backed technology companies. It is the only way we can compete for talent with the cash compensation, benefits, and perks of publicly traded tech companies. I have personally been part of “wins” where the exit value of the equity has created life-changing financial returns for hundreds, if not thousands of my co-workers and employees. With a lot of hard work, some strategic pattern matching, and a little luck joining a technology startup can be a path to building wealth and achieving the modern American dream.

Once you have made the decision to accept a job at a technology startup, the most important thing you can do individually is to work your tail off while helping your peers, your boss and your employees navigate the ups and downs of value creation. Of course, you need to think strategically about advocating for yourself with regards to cash and equity compensation - this is part of managing your career. But understanding how your company maintains its 409a valuation is super important.

409a valuations become relevant to employee shareholders in two situations:

1. As previously discussed, when employees need to choose whether to exercise their options before the stock is liquid, the most recent 409a valuation is a major factor in determining the amount of the tax obligation. This tax obligation can be significant - sometimes substantially greater than the exercise price - and forces a serious economic decision for option holders. When the situation occurs that the 409a has not been updated to reflect a turn in market conditions, the real risk-return value of an option grant can be severely impaired.
2. When new employees are hired, the exercise price is usually set to the current 409a valuation.?The idea is that new employees should be able to share in the value created from the time they joined a company.?Confidence that the 409a has been properly maintained is important – particularly when there have been shifts in market conditions that impact company value.?

The bottom line is that 409a valuations need to be accurate. The 409a needs to be adjusted frequently during volatile times to make sure that employees are not duly disadvantaged by a mispriced 409a that results in employees paying higher AMT taxes. And just as important, properly maintained 409a ensures employees are not granted options with unreasonably high exercise prices that reduce the value of their equity compensation. Responsible maintenance of a company's 409a valuation ensures the integrity of equity compensation - supporting both recruiting and retention.

I am not the only one writing about this topic and am glad to see this is being openly discussed. I particularly liked this piece in TechCrunch from a few weeks back - WTF is a 409a Valuation?

As always, glad for thoughts and feedback.