Valuation Shell Game: the 409A valuation | Hacker News Reader

Valuation Shell Game: the 409A valuation

nytimes.com

34 pointstim_sw24 comments

The fact is that nobody can really know with certainty the true valuation of an early-stage company. Even venture investors just come to a negotiated deal and subsequent events often prove them wrong. That said, the definition of true value is probably whatever price is implied by a market deal between a willing seller and buyer both of which have access to all relevant facts and neither of which is under any compulsion to do a deal (so basically a venture capital transaction would qualify). The article correctly points out that valuation firms aren't market participants (i.e., actual buyers) so they are just doing their best to guess at a value--not establishing a value. The article also points to false precision--which most honest valuation folks agree to. They still have to do their best to come up with a defensible valuation but they recognize that it is just an educated guess. Finally the article points to the difference between common and preferred stock prices as if that is a scam. While you can definitely debate how close the two should be relative to each other, it's totally crazy (IMHO) to say that common should have the same value as preferred.

On Tuesday I spend a hundred bucks and start a Delaware LLC that has no assets and no business plan - what's the company worth? Most would say $0 or close to $0.

After breakfast on Wednesday I spend a couple hours on an abstract powerpoint deck, make a bunch of phone calls, and by dinner time (based on past successes and personal network) I have $1m in seed funds committed at a $5m pre-money valuation. What's the company worth then?

It's one of the best tax incentives out there, in that successful founders and very early employees usually pay long-term capital gains on near zero-basis stock.

Couple of things that are not correct in the article:

(1) a $50,000 fee for a valuation is crazy- early stage companies pay less than 1/10th that.

(2) companies typically do not get a valuation done more than once per year. the article makes it sound like you get a new one every time you issue options, they actually have a shelf life of one-year, unless there is a new financing or other event that requires a new report to be obtained.

Not saying its a good system (it's not), just odd that the NYT would get some basic facts wrong.

The funny thing is that the author of this article is a former (longtime) investment banker. I found the line where he describes the lack of liquidity in private shares "falls especially hard on early investors who are not company employees, those so-called 'series A' or 'series B' venture-capital investors" especially amusing. As if we are supposed to feel more sorry for VCs who are diversified in many investments than employees who aren't.

I completely agree with this. 1) I have never seen a startup pay anything close to that. 2) you are so right--you generally only need 1 every 12 months (at most!). There are some exceptions but they are rare. Some valuation providers sell 409As as if you need them monthly or something. That is absurd.

Thanks for calling out these major factual errors. I can confirm your corrections. What a terrible article!

I would imagine that it could also be bundled in with the other legal and tax services a growing startup requires?

We need an overhaul of private stock options in general. These shares sit at the bottom of the capital stack which means as that stack gets higher risks increase. The fact that someone needs to pay tax before these options are excerised is ridiculous. If the US wants to stimulate innovation they should stop gouging risk taking employees and focus their efforts on Wall Street.

We scam you with the 409a and you scam us with the AMT.

This is... Actually beautifully succinct.

Getting a 409A did seem to be pretty dumb. It's just a super-expensive process to figure out how much taxes you have to pay on option grants. If the rules were just, a grant of startup stock doesn't get taxed until an IPO or acquisition, so you don't have to do options in the first place, that would be much saner!

Btw, full disclosure I founded and sold Scalar Analytics, a valuation firm and am currently the CEO of Capshare.

The article says that 409a valuations are imprecise, costly, and unnecessary tools that enable founders to prevent the secondary sale of company stock, and disenfranchise employees and early investors.

This is almost 100% hyperventilation.

I took to Medium to try and explain that 409a valuations are: a government-required, largely commoditized service; a consistent, objective approach to dealing with the uncertainty of startups; nothing more than the translation of the startup’s underlying business fundamentals.

Link: https://medium.com/@tim.riser/startup-valuations-are-no-shel...

This article is frustrating because it never mentions why low 409A valuations would be helpful to anyone. It seems to say the companies are benefiting from different 409A and investor valuations, but not why. Does it mean someone pays less tax or something?

If you give an option where the strike price is "the current fair value", the employee doesn't have to pay taxes. But "the fair value" is defined by the 409A. The company usually doesn't care about the strike price and would rather just give the employee as much value as possible. A low 409A is much better for the employee, a teeny bit worse for the company, and so companies just go for a low one.

The 409a value is the strike price, say it's $1. Your investor comes in and buys for $10. Every new employee that comes in, you say 'you can buy it for $1 and sell for $10, so each share is worth $9,' which is basically lying to make the comp package sound better and hire people for less money. To be less cynical, the lower you force the strike price, the less anyone getting new shares has to pay to buy it. Early on, it's much easier to early exercise and buy them if its cheaper. Everyone gets more profit if they can buy at a discount, so they try to discount options as much as possible

Lower cost basis for all your equity.

It's pretty common knowledge that 409a valuations are underestimations of real value. What isn't well known is by how much. It would be great to see VCs with 20 years of data compare how much their preferred shares were worth vs of they had held common instead. Then again, publicly available data like that might invite an SEC crackdown. Be careful what you wish for.

My understanding is the 409A is supposed to be a true valuation of the company, not of the shares. The price of shares sold to investors (probably with liquidation preferences, extra voting rights, maybe a board seat, etc) of course costs more than the company's value divided by number of shares.

409a includes the valuation of the stock held, which is often discounted by "accepted discount factors" such as illiquidity discount and marketability discount. The latter being the fact that a common shareholder often has resale restrictions on their stock.

It's both, they start by calculating enterprise value, then from there estimate the value of the common stock taking into account the things you mention - then divide that by number of shares (including those expected to be issued shortly).

If you are going to tax values of the shares then you have to decide _some_ price. What is the alternative? Using the last financing round is just as crazy and even easier to game.

A simple alternative would be to tax startup shares when they turn into real money, not when they are granted and all sorts of shenanigans are possible around their value.

Exactly. The current system is taxing eggs before they hatch into chickens. You're paying taxes on potential income rather than actual income. If the eggs break before they hatch -- too bad.

The weird thing is that if a stock loses value, you can't claim a deduction for the loss until that loss is actually realized, yet you can get taxed on shares before any gain is realized.

It's all Monopoly money until it becomes actual cash.

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