The Real Impact of 409a

I haven't posted much on the IRS regulations (called 409a) that are forcing most of our portoflio companies to spend time, energy, and money getting third party valuations done of their common stock to ensure that their employees don't end up with tax liabilities.

Brad Feld is the "axe" on this issue having posted on it no less than 14 times so far.  So if you feel like you need to get up to speed on this issue, you should read his posts.

We've taken the safe route and the vast majority of our portfolio companies have hired third party valuation consultants to determine the fair market value of the common stock which is the price the options get struck at to insure that there are no tax liabilities for the employee upon issuance.

And guess what?  Most of the valuations that have come in so far have been lower than the fair market values previously determined by the companies and their boards.  It's counterintuitive but when you think about it the boards have erred on the side of being conservative and the consultants are working for the companies and trying to please them.

So the IRS has handed a gift to the companies and their employees in the form of lower strike prices. Thanks, we'll take it.

Chalk it up to another case of regulators seeing a problem where none existed and actually creating one in an effort to fix the non-problem.

Comments

[steve]

how expensive are these third-party audits? how much differential in common share price determination?

in the end, is it worth it?

[JayR]

I'm curious as to whether you're seeing this across the board in your portfolio companies, or is the discounting more pronounced at the earlier stages. The latter is what I'm seeing.

[Eric]

Bay Area VCs have become obsessed with the 409A issue; two investors recently observed that discussions of 409A have taken up a disproportionate amount of time in board meetings they attend.
To Steve's questions:
* The cost has dropped into the $10,000-$15,000 range per audit. (Audits reportedly were priced as high as the $20,000 range in mid-2005.) There are firms that will perform these audits for <$10,000, but most established VCs prefer a 'name brand' as insurance against a future IRS audit.
* Given the prospective tax consequences, it's absolutely worth it. To their credit, most VCs who've discussed the matter with me have noted that, while the majority of the employees of their companies are unaware of the issues with 409A, they've supported audits as "doing the right thing".
(And, yes, they protect the company against possible lawsuits and their firms' reputations as fair-minded to talent. In my experience, the VCs like Fred who've backed audits have been emotionally invested in doing the right thing by their portfolio companies' staffs, and often are a little bit angry at how the 409A regulation has put the rank-and-file people who build their companies at some risk.)

[just.a.guy]

I've seen the same thing in the portfolio companies I work with. I half-joked when 409a was first coming out that "even for some of our best-performing companies I can make pretty clear cases from multiple angles why their option strikes should actually be zero."

Turns out I was more right than I thought. Rather than the old 10:1 discount ratio that was the prior rule of thumb, I've seen rational math come up with 12:1 - 15:1 for many companies.

To the earlier question, it's indirectly a function of company stage, but more directly a function of amount of preference overhang.