409a valuations set the price of the common stock generally after preferred stock has been purchased by the investing angel or venture capitalist. Preferred stock might have been purchased for a dollar a share—but once preferred stock has been sold by the company, it has to be paid back first before common stock has any value.
So imagine an extreme situation where a company which just started last week raises $80 million in preferred stock. The odds that the full $80 million is ever even paid back is probably low so it wouldn't be crazy to see the common stock valued at almost zero/nothing. Employees get stock options in common stock—not preferred—so somebody has to set the strike price for the options on their common. That's the purpose of the 409a valuation—it sets the price at which common stock options can be bought and thus converted from options into actual stock ownership.
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Finance: What is a 409a valuation?29 Views
finance a la shmoop. what is a 409a valuation. it has nothing to do with that
cleanser thing. yeah get that out of here all right. [cleaner scrubbed across a counter top]
well after a lab accident you were inspired to start a new company which
produces glow-in-the-dark bunnies .great Christmas gifts until you get bored with
them yeah. then you think well really cool glow-in-the-dark Stew.
you're the founder of globe bunny and you raised two million dollars in
preferred stock from investors. like most startups your shares are common stock so
if the company fails the investors get paid before you do. like if you sell it
for scrap. you need to grant stock options to
employees you're gonna hire. like you know your chief carrot officer or
executive vice president of adorableness. well you need to grant stock options to
those key officers but how do you price them like how do you set the value or
the strike price of those options ? well you own 4 million shares of common stock
and investors own 2 million shares of preferred priced at $1 each. that
preferreds a buck a share .so notionally your stake in the company is worth 4 [equation]
million dollars. but glow bunny barely has even a product. well ok it's a cute
product it's just kind of creepy. but it has no revenues and certainly no profits
so glow bunny is still at a highly vulnerable stage where it's very likely
to go bankrupt. statistically some 98% of these kinds of
startups either go fully bankrupt or pay back less than what investors you know
invested. so the 4 million shares common stock are certainly worth less than the
4 million bucks at this moment right? and it is the common stock which is the type
of stock which employees will get stock options in. that is an employee starting
at the company might get a modest salary and then a hundred thousand stock [equation]
options which convert into shares of common stock at a price. so the question
is what price are what strike price applied to those stock options is used
to set the price at which an employee can buy out those shares of stock? and
this pricing is a big deal because if the CEO just wants to gift to the
employees a super low strike price number
the IRS will view that as a taxable event and then bad things happen to
pretty much everyone. like it's a gift tax in that's taxable right ?well it's
the 409a valuation which determines that strike price and like Goldilocks
porridge you want it just. right if it's too high the employees don't get value
for taking the risk of working for the volatile startup you've started at a low
salary .and if the stock options are too low or priced too low well the IRS comes
a-callin .yeah Goldilocks. alright so the process a 409a valuation is made by
calling a lawyer or a bank who produces these valuation reports regularly .you [man on the phone]
know for a modest fee and yes glow bunny will pay them a modest fee .and in return
the firm will produce a piece of paper stating their rationale as to why via
say 4 million shares of common are really worth just a dime each not a
dollar. but they'll always be in a discount to the price per share of the
preferred stock because preferred always gets paid out ahead of common stock in a
liquidation. and there are multiple analyses the firm will look at. like 1
the price preferred shares were bought out like that dollar. 2 discounted cash
flow analysis of the projected revenues and profits and all that stuff over the
next n years. and or 3 comparable values for companies that are in similar or
ancillary spaces in like what their 409 a's were priced at at the same time. got [analyses of stock pictured]
it so a whole bunch of things go into the soup here or stew. and it's re
different not bunnies stew. now looking at you .alright and if they come up with a
diamond share well then it will be that diamond share that will be the strike
price of the options granted. meaning on the 4 million remaining shares they're
saying they're worth and give or taken four hundred grand. so if an employee who
just received one hundred thousand stock options in glow bunny with a diamond
strike price wanting to buy out their stock options and actually be a full
owner of the common stock as opposed to have options on it well they would need [equation]
to write a check for a hundred thousand times a dime or ten grand to glow bunny.
they would be the proud owner then of those hundred thousand shares of common
stock and because glow bunny and conveniently over stocked this corridor
well your very own truckload of bunnies. yeah there you go have fun cleaning that
up, and believe us when we say that everything about these bunnies
glows. [glowing bunny poops]
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