Founder’s Stock Sale — How Not to Turn it Into a 409A Nightmare
Published on 24 Jun, 2016 Published under Valuation
A Founders’ Stock sale can have serious and far reaching implications on the pricing of stock options due to 409A provisions.
While the extent of the impact can vary significantly, it’s important to understand when this affects companies the most as well as how they can structure such transactions to mitigate these effects.
Trends indicate that venture capitalists have increasingly become comfortable with providing partial liquidity to the founders, which often occurs during new financing rounds. In most cases, this is achieved by facilitating the buyback of a portion of the Founder’s equity (typically common stock) by the Company out of proceeds of preferred financing round or sale of founder’s equity directly to the investors.
Founders typically own common stock, and while common options are valued at 15%-40% of preferred stock price (depending upon the company’s stage of development), founders’ stock is mostly sold at the preferred stock price. With the 409A regulation in place, such a transaction triggers the arm’s length presumption, and can lead to the Founder’s stock’s sale price arguably becoming the new benchmark for pricing future options.
Needless to say, unattractively priced options can severely impact a company’s ability to maintain employee motivation — a situation that start-ups can ill afford.
While a Founder’s stock sale certainly has an impact on 409A valuation, the degree to which it affects the company’s valuation varies significantly. What matters here is to understand when this impact is highest, and what a Company can do (before and after the transaction) to minimize the impact.
Although the actual impact depends upon the facts and circumstances of each case, here are some factors that determine how the transaction price affects 409A valuation, and thus, be taken in cognizance by a CFO:
- Is the Founder’s stock sale facilitated through Company buyback, or is it negotiated directly between founder and the investors?
- If it is a buyback, and the Company has bought back common shares from founders, has it issued the same class of shares (common) to new investors, or has it issued a different class of shares (preferred) to new investors?
- Was it a standalone transaction, or was it in conjunction with a capital raising transaction?
- Was the option to sell shares restricted just to founders and/or a select group of management personnel, or was it open for all common shareholders.
If yes, was there any limit on number of shares that can be sold as a part of the transaction?
- What was the key objective of this transaction?
Was it to give liquidity to shareholders/founders; or was the transaction structured to give a minimum required stake to new investors, without raising excess capital?
An experienced Valuation Expert would evaluate all these questions, and much more, to see if (and how much) consideration is to be given to the transaction for 409A purposes. He can always identify any unique anomalies that limit such consideration, and demonstrate how the transaction price in question is not at arm’s length, and thus, not a good proxy for option price. More importantly, he or she needs to document all relevant data-points and arguments coherently in a 409A report.
A skilled CFO on the other hand will make sure that:
- He speaks with his 409A valuation firm during the initial stages of planning in order to understand the impact of the various transaction structures being considered.
- He apprises investors on the need to be flexible with the transaction structure being considered in order to ensure there's no adverse impact on the company's 409A valuation.
- He discusses the transaction's objectives (both the buyer's and the seller's) with his attorneys and valuation firm in order to determine the most suitable structure that meets their desired objectives.
In the end, the 409A impact of a Founder’s stock sale should never be a reason to deny Founders their well-earned right to make partial exit, nor can it be allowed to affect your employee’s motivation. The job of a CFO and his valuation partner is to ensure the two don’t conflict, and a good understanding of some of the above points would go a long way toward ensuring that.
Manish is a qualified Chartered Accountant (CPA equivalent in India) and a CFA® level 3 candidate, with over eight years of experience in business and intellectual property valuation, project finance and transaction advisory services across diverse industry sectors, particularly technology and healthcare.
He currently manages the team focused on intellectual property valuation and deal advisory for middle market investment banks and PE funds.