Late-stage tech companies must do right by their employees: Reassess your 409A valuations

This post originally appeared in TechCrunch

Last year was a great one for startups. It was a record year for companies going public, valuations for pre-IPO companies were skyrocketing, and fundraising also shattered records.

But 2022 is going to be quite different. Many of the companies that went public last year have seen their stocks plummet, and those woes are seeping into the private market as late-stage tech companies are starting to see their valuations trend downward.

While nobody can predict the future, lowered valuations aren’t as much of a foreboding sign as they’re made out to be. Just as what comes up must go down, what’s down will most likely go back up. But while things are on the downswing, there is a unique opportunity for startups to reduce their valuation.

Yes, reduce. Trying to maintain an inflated valuation doesn’t necessarily do you any good. What’s more, it can actually harm your company’s future growth.

Though it may seem counterintuitive, a lowered valuation could reap benefits for your employees and your company’s recruitment efforts. On the other hand, a high valuation increases the cost to exercise, or buy, those stock options.

A lower valuation will ease those costs and make equity packages more attractive to new hires, especially in a job market that is red hot with recruiters competing for talent.

What is a 409A valuation and why is it important?

Stock options are granted a specific price, known as the strike price. The strike price will be similar to the 409A at the time the option is granted, and that never changes. What does change is the company’s valuation, and that is reflected in the 409A valuation. That, in turn, impacts the fair market value (FMV).

When an employee goes to exercise, or buy, their options, they need to pay taxes on the difference between their strike price and the current FMV. That’s because the IRS counts the increased valuation of the stock as income, which could be subject to income tax or the alternative minimum tax (AMT).

Many employees take a “wait and see” approach to their equity. Once they believe their company has “made it,” like reaching unicorn status, they feel it’s less risky to go ahead and buy their stock options.

For new recruits, a lower 409A valuation will translate into a lower base cost of their equity. This makes job offers more attractive, as a dip in valuation doesn’t necessarily mean the company won’t have a healthy exit. For current employees, it means they can pay less to exercise their options and be better prepared for a potential exit.

For example, Instacart filed to go public after announcing a valuation cut with the explicit message that it would improve compensation packages for new hires.

What impacts a company’s 409A valuation?

The 409A is determined by an external agency. It’s reassessed once a year as well as any time there’s any material impact to the company, like a new round of funding.

With market conditions being what they are, this is what the assessors will be looking at:

The amount and type of capital raised

Assessors tend to focus on the various rounds of capital that have been invested in the company, and at what terms. The terms are important, because investors get different rights and guarantees with their stock, typically referred to as preferred stock.

Employees and founders, however, get common stock, and are last in line to receive cash from any exit. If your company has raised new funding from a VC at a flat or lower valuation, it’s likely the capital that was first in line will be paid back on a down exit (hence, they get preference). This also means the value of common stock should decrease.

Recent secondary market transactions

The public market’s sentiment that’s seeing a reduction in the value of tech stocks is also trickling down into the private market. For example, Forge Global, a major secondary market for private stock sales, has seen a 37% decrease in revenue year over year (Q1 2021 to Q1 2022) mostly because there is a large discrepancy between buyers and sellers.

Sellers are still trying to sell at the same price as six months ago, while current buyers are valuing the stock at far less. If any of your employees have sold their stock on a secondary market, and the value of recent transactions has decreased, this can have a material impact on your 409A.

Projected cash flow and future business plan

As the bull market fades, and a bear market potentially ahead, many private companies will, and should, adjust their business plans. This will affect your discounted cash flow (DCF) analysis, which could lead to lower valuations.

The multiples of similar companies

Similar to how a house is appraised based on recent sales of similar houses in the area, company valuations are also affected by sales of similar companies. And, like a house appraisal, this data point could be the most significant factor in your company’s valuation.

This is already being impacted by the current market, so let’s dig a bit further.

The last few months have seen an unprecedented drop in tech stocks. For example (as of May 27, 2022):

• Robinhood: Down 83% since a high of $62.90 per share.
• Snowflake: Down 68% since a high of $401.90 per share.
• Affirm: Down 82% since a high of $168.50 per share.
• Palantir: Down 77% since a high of $39 per share.
• Asana: Down 84% since a high of $142.70 per share.

If you’re a consumer fintech or a marketplace, the decline in Robinhood’s and Affirm’s stock price could impact your multiples and your company’s 409A valuation. If you’re a late-stage B2B SaaS company, your revenue will now be compared to companies like Snowflake, Palantir and Asana, all of whose multiples have declined significantly this year. Again, this will have an impact on your 409A.

Let’s take a closer look at what’s changed since November 2021:

Last year, a $100 million in SaaS revenue could have brought you a $5.7 billion valuation based on Snowflake’s 2021 multiple of nearly 57x. But now, with a multiple of 15x, your company will only be valued at $1.5 billion. The impact on your company’s common stock, and the 409A valuation, is clear.

So why reevaluate the 409A in this market?

As noted above, all of these factors and related multiples have a major impact on a company’s common stock valuation. If your current 409A was last updated between March 2021 and March 2022, you are very likely being compared to multiples that are no longer relevant.

This means reevaluating your 409A now is actually the right thing to do for your employees, because their equity isn’t up to date with the rest of the market.

Again, equity is meant as an incentive and a reward for joining an early-stage company and putting in the hard work to take it public. But that incentive is lost if the cost to invest — because that’s what stock options are — is out of reach to begin with.

In addition, individuals exercising their options now will have to pay tax on the difference between their strike price and the 409A. This is real money they won’t get back. Paying unnecessary taxes is not just a waste, it could also mean your employees are paying more for their stock than it’s actually worth, effectively putting their stock underwater.

What about employees who may already have a strike price that could be higher than a new 409A? This is another key reason to reassess your 409A, because you can easily reissue that stock back to them at a lower strike price. This gives them a more attractive equity package, while showing them the effort you’ve made to put them in a better position.

The best founders and CFOs will do the right thing for their employees by making sure they are rewarded fairly, don’t pay more taxes than are necessary and have aligned their incentives with the company’s success. It’s time to talk to your 409A evaluator and ensure you are doing all you can to help your employees.