How a Sloppy 409A Valuation Nearly Cost This CFO $600,000
What is the real cost of a 409A valuation?
As startup-focused valuation providers, we often talk to founders and CFOs of early-stage companies who suggest a couple thousand dollars is sufficient to obtain a 409A valuation. While it may be true that’s a price quote from a low-cost automated provider, it’s rarely the real economic cost for the startup – or its team – when all is said and done.
Nowadays, the story of highly capable executives foregoing cash compensation for potentially lucrative options grants is a familiar one. But what’s misunderstood is the other element that’s critical in the deferred compensation equation: The valuation of those options at the outset.
Early-stage valuations matter – immensely.
This is a story about how a few thousand dollars today can have six-figure consequences tomorrow.
The “Startify” story
Take, for example, one of our current clients. It’s a fast-growing, venture-backed company. In the interest of confidentiality, we’ll call it Startify.
A couple years ago, Startify was an early-stage startup experiencing a “hockey stick growth.” Its compelling growth story was attracting top talent. Highly capable executives were being enticed onto the Startify team with minimal cash incentives, instead lured by the promise of a significant future payout from the options grants.
We got a call from Startify shortly after one of its first financing events involving institutional capital. On the other end of the line was its recently hired CFO. We’ll call her Sarah. Sarah had worked with us previously as CFO of another company, and she’d been through the 409A valuation process before. She was also a seasoned, high-performing executive.
She gave me a call and said, “Look, I just joined this young company. It has a lot of potential, but it’s such an early-stage venture that the risks are substantial. I’m looking at a recent draft 409A valuation they obtained, and it looks like those risks are not accounted for properly. Could you provide me with a second opinion?”
Interested to hear about Sarah’s new venture and to see how we could help, we caught up with Sarah on Startify and walked through the approaches and assumptions used in its prior 409A valuation.
Sarah was curious to hear our thoughts as a fiduciary of the company, and she also recognized she had a personal interest. Sarah noted that a significant portion of her compensation package was the grant of options that would be priced as soon as the board of directors approved the 409A valuation. Given her prominent role as CFO, this wasn’t a small pool of leftover options. For a proven executive like Sarah to take the risk of joining an unproven startup, the board had granted her 1,000,000 options. In the event of a successful exit, her potential payout could be substantial.
The company had just received – and paid for – the 409A valuation performed by one of our competitors, which was also an automated provider (what we call a “robo-appraiser”). That analysis concluded on a common value per share of $1.64 which Sarah felt was too high.
With this context in mind, our phone conversation centered around the following factors that were pertinent to Startify:
The company’s business model (to consider current and future profit margin expectations, among other factors)
The expected near-term challenges and opportunities that could change the trajectory of the business
Management’s expected exit scenario and the potential time to reach that exit
Management’s insight on the companies that are comparable to Startify in the industry (public and private)
Startify’s cash runway and any expectations around future financings (should they be required)
After our 30-minute discussion, we agreed that several key factors were not adequately incorporated into Startify’s last valuation. Sarah decided not to rely on the sloppy valuation currently on her desk, and instead engaged Redwood to perform another 409A valuation.
Our team worked diligently to turn our valuation around quickly and professionally. We conducted a thoughtful analysis of the company, the industry, the market environment, the various stakeholders – management, backers, etc. – and the various potential outcomes for the subject company. The result of our analysis, judgement, and the calculations in our thoroughly-vetted model was a valuation that came to a concluded common stock share price of $1.04 – a full $0.60 less than the competitor’s valuation. In percentage terms, that is a 36% reduction in price for Sarah and her team’s forthcoming options.
Upon presenting our valuation to the CFO, she realized the difference it can make to hire a qualified and experienced valuation team versus an outfit cranking out cookie-cutter models. Insights from a team of seasoned appraisers can move the needle on the outcome while also staying within defensible boundaries should the IRS ever inquire.
If the company has a successful exit, Sarah will receive an additional $600,000 in proceeds ($0.60 times 1,000,000 options) versus what she would have received if the company had stuck with their old valuation provider’s analysis.
Be wary of cut-rate appraisers
When selecting a 409A valuation provider, the cost of the analysis as well as the potential opportunity cost to the option recipients should be considered. As with the situation above, the upfront cost of the valuation may be insignificant compared to the loss of future payout that results from hiring the wrong valuation provider. When it comes to 409A valuations, savvy executives realize it doesn’t pay to be penny-wise and pound-foolish.
About the Author: Tim Montgomery has performed 409A valuations for more than a decade. He also specializes in ASC 820 portfolio valuations and has supported 40 prominent venture capital and private equity firms in this capacity. Get in touch with Tim directly at tim@redwoodvaluation.com.