Valuations 360: Understanding the 409A Process and Avoiding Pitfalls

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Valuations 360: Understanding the 409A Process and Avoiding Pitfalls

Sean Sutton:     All right, everyone, welcome to our Valuations 360 Workshop: Understanding the 409A process and avoiding pitfalls.  My name is Sean Sutton.  I'm joined here by Steve Liu, who is the Co-Head of our Valuation Services Practice in the Global Private Markets Group.  Steve has personally overseen over 10,000 valuation opinions throughout his career at Morgan Stanley at Work, Silicon Valley Bank, and the Big Four.  Prior to Morgan Stanley, Steve was a Valuation Practice Leader at SVB, advising start-up clients from the incubator stage through pre-IPO.  So we're very excited to have Steve here to chat with us about 409A.  So thanks for being here, Steve.

Steve Liu:         Thank you, Sean.  And I have the pleasure of introducing you, my colleague, Sean Sutton, who's a manager in our Morgan Stanley at work Valuation practice within global private markets.  Sean is one of our senior members of the team.  He's a 409A subject matter expert, he has half a decade of experience completing tax and compliance valuations, and he's seen everything from the incubator stage through to pre-IPO.  So it's great to be here with you.

Sean Sutton:     Awesome.  And in terms of the roadmap for the workshop today, we have a lot of content that we want to get to for you all.  Given the state of the world and sort of where we are in the VC markets, we wanted to just start there and have Steve give a little bit of an intro and an overview in terms of how he's seeing things in the market and in his mind what's going on.  And then we wanted to just give sort of a broad overview in terms of 409A valuations and introductions of what they are, why we need them, selecting a vendor and what that process looks like, as well as the actual valuation process itself.  How would my private company go through evaluation, what would that look like?

            And so before we really jump into the content, wanted to just say if there are any questions that the audience has that we don't get to today, please send those to us.  Submit those questions and we will address them on a one-to-one basis following the workshop.  So with that, let's get started with sort of the state of the venture market.  Steve, why don't you go ahead and take it away and tell us where we're at?

Steve Liu:         Yeah, Thanks, Sean.  And I think when we think about valuations and the private markets, the best place to start is looking at kind of where we stand now.  It's a good way to frame up how we think about valuations and we'll certainly go into detail.  And it's certainly been a tumultuous start to the year.  I think on one hand I'm personally encouraged by the robustness of the private markets.  For the past several years we've had a lot of gyrations in the public markets and that volatility, for the most part, has not seeped into the private markets in general.  And Sean, you can certainly talk to this, we've seen valuations continue to increase, companies have been able to get access to capital funding.  But in the second half of last year, we really saw the penny drop.  And it's been a minute and we should really take note of the trend lines which, with the exception of seed-stage companies, have all declined.

            And so whether you look at the volume of transactions, you look at valuations, you look at capital raise, it's been a really difficult market if you're a start-up founder.  And so as we think about this year and what's to come, there's some really interesting areas that we can dive into.  What used to be a water cooler topic, repricing, certainly now has become much more of a reality.  And we're seeing that happen more frequently this year.  When we think about access to capital, it certainly is more difficult.  Even though the dry powder index still remains high, VC investors are hesitant to invest in companies.

            And so, YC, if you look at some of the advice that they gave to their start-up founders was if you're optimistic about your business, think again.  If you think that you can get quick access to capital, think again.  And if I could take their message and shorten it down, it's manage your business well, make sure that your runway is extended, and cut burn.  And so this is the environment that we're living in and more and more now we're seeing how what's happened in the public markets has really come down into the private markets and it has certainly impacted how we think about 409A valuations.

Sean Sutton:     Awesome.  Super, super important context, and hopefully, provide some good info to the audience as far as where we are in the market today.  But switching gears a little bit and maybe getting more so to the 409A-specific side of things and the world that we operate in more frequently, just as sort of an introduction for the audience, on your mind, what is a 409A valuation, why are they needed?

Steve Liu:         Yeah, why even call it a 409 valuation?  And the first thing to key in on is it is an IRS compliance requirement.  So the 409A refers to that.  It wasn't always the case, if you look back historically, companies were able to price their own equity and then we had a lot of abuses in the public markets in the early 2000 with Enron.  And really that started to catch the attention of the IRS and the SEC.  And what we now see with the 409A regulatory requirements.  But simply put, if you're an early-stage founder and you're looking to issue out equity, you need to establish a fair market value for that equity and you need to have an independent valuation.  So that's the other important piece.

            And so what the 409A does is it provides that benchmark of value for the equity that you're issuing now.  And that's important for a number of different reasons, not the least of which is the tax implications and making sure that from a comp perspective, it's tax-exempt.  So, a simple example, if I'm a start-up company and I'm issuing out equity to you, Sean, at $10 per share and the IRS comes in and decides it's actually worth $20 per share, that creates a tax liability.  And then there are penalties that stack on top of it.  So there are all sorts of concerns and challenges that come when you do not have a compliant foreign valuation.  And then, of course, the needs of the start-up change over time.  And so maybe, Sean, you could go a little bit into the 409A process, what it looks like, how that changes, and some of the considerations that a founder should be thinking about.

Sean Sutton:     Yeah, for sure.  So I think that the first piece to call out is I'm an early-stage company, typically you're getting your 409A refreshed once a year.  So a lot of companies choose to go on an annual cadence.  They choose to - we see a lot of companies go with year-end valuations, they think it's clean just to tie it to that year-end.  So when you're an early-stage company, about a year or so, get your 409A refreshed.  You're good to issue options.  That changes over time as your company grows, and specifically, the sort of wrench that gets thrown in that equation is when we raise capital.  So I'm a young company, I raise a financing round, all of a sudden that's a material event that in the eyes of the IRS, we need to refresh our 409A on a more frequent cadence.

            So even if you have a useful life left on your initial report but you raise financing six months since your last valuation was done, it needs to be refreshed.  And so now in a similar train, as the company progresses even more, gets closer to an exit, starts to think about an IPO and timing and what that might look like, we see a lot of those companies choose to start to renew their 409A on a more frequent cadence.  Maybe that's twice a year, and as you get even closer to an IPO, it ends up being quarterly or even sooner.  And sort of the reason why that's happening is as your company enters that stage and gets closer to an IPO, you're changing - the company is changing very quickly and so we need to make sure we're refreshing the 409A to account for those changes.

            And then one piece that a lot of folks don't necessarily realize is we say there's a 12-month shelf life on the 409A and so after that 12 months you should refresh it.  The caveat there is it's really if you're issuing equity, because if I'm a company and my 409A expires but I don't have any plans to grant any equity in the near term, there's technically no requirement that says you have to renew your valuation.  And so if you want to pause a few months before getting that new 409A done, fully free to do so.  So as far as timing goes, that's typically how we think about it on our end and typically what we see with some of our clients.  But as far as selecting a vendor and sort of what to look for, Steve, would you mind talking about some of the things that you've seen over your career and what to look for in a vendor?

Steve Liu:         Yeah.  There certainly are a lot of considerations, but if I was to distil it down to sort of one word, it would be experience.  And there are couple different ways that you can think about experience, one is just valuation work that a provider does, and there's sort of breadth and depth.  Hopefully, you have both.  And here at Morgan Stanley work, certainly, we always share with our clients the number of valuations we've done, and we've done thousands of them.  But the number that I probably take more pride in, frankly, is the number of clients that we've been able to complete the journey with them from that early start-up stage, two people and a dog in a garage, all the way through up to a pre-IPO.  Because to your point, the complexity of the valuation changes significantly as a company matures.

            And so the things that you think about in the valuation early on are very different from a pre-IPO client.  And so if you've done thousands of valuations and they're all early-stage clients, you don't necessarily have the experience and perspective to bring when that company is thinking about an exit.  So there's that piece of it from the client perspective, the company perspective.  But then thinking about the 409A, and this has to go back - this goes back to the compliance aspect, there are a lot of interested parties in founders' 409A.

            It's not just the start-up but it's your auditor, it's the SEC, if you're thinking about the IPO, it's the IRS.  And each has a different lens through which they view the 409A.  And particularly, for later-stage companies, your auditor probably is going to be the first gatekeeper where they're reviewing your valuation and they've got an army of valuation specialists that are scrutinizing the analysis that's been done.  So there's a defence that your valuation provider has to provide.  And then later on, the SEC, if you're at the IPO stage, is going to be scrutinizing the history of your 490 valuations.

            And so it's super important to us, for our team, when we are dealing with our clients, is to have that experience and knowledge.  And many people on our team have experience from the audit advisory world because it really helps to bring a different type of lens to the 409A valuation.  And you'll want to have a provider that has experience there and is comfortable defending your valuation.  And I think if you have that experienced valuation provider, then accuracy and transparency, all of those things will fall in place.

            And then the last thing I'll mention, and it's a bit of a plug for our cap table platform, but if you think about valuations and what goes into it, one of the key pieces of information is a company's cap table.  And if you don't have the fidelity of information, you're just not going to have a clean valuation and leads to all sorts of problems.  And similar to valuations, you want a cap table platform that can grow with you, that can handle the complexities of your business so that when you're doing a 409A, the last thing that you have to worry about is your cap table.  So I think we're certainly - I feel relieved when we have a valuation client that's already on Shareworks.  And those are some of the things that we think about as we go through it.

            So I guess you've talked a little bit about the 409A valuation and some of the larger considerations, but maybe, Sean, you could give a little bit more insight as to what the typical process looks like.  The cap table is one piece of information that goes into the 409A, what are some of the other considerations?

Sean Sutton:     Yeah, absolutely.  So the cap table is a huge piece of the valuation.  And so the process, especially at Morgan Stanley, will typically look like collecting due diligence from the subject company, the company we're working with.  Once we've got that due diligence collected, we're reaching out to the client to set up a management call, it's sort of what we call it.  And so that conversation ends up being anywhere from a 30 to 60-minute call where we're - it's really our opportunity to sort of ask 21 questions, go through a fact-finding exercise, dig into the company's business model, our competitors, our history, our financing, where we think we're going over the next year or so, touch on the forecast.  So it's our opportunity on the valuation side to really understand the business that we're valuing and figure out how to incorporate that into our model.

            And so following that call, my team will get to work on building the actual valuation itself.  And so customizing that model based on how the conversation with management went.  And then once we've got the actual model built out and we have a deliverable ready, we share that with the client.  And from there the process can be very quick, if the report is received and the company is happy with the result, they just give us the green light, and the process is wrapped up from there, we send them the final. 

            But I think one of the things that makes us different or unique is that we really try and provide sort of that white glove service.  And so if we send over something to a company and they're not - maybe they want to ask some questions in terms of how the valuation is working, how did we select the methodology that we selected?  What did we - what are some of the value-driving assumptions?  We're happy to get on that on a phone call with the company and walk through that, make sure they're comfortable with what we're doing.  And potentially there's even a situation where maybe we were too aggressive in setting some assumptions, maybe we were too conservative and we need to sort of deliberate on what makes sense and get to a place that both parties, us on the valuation side as a client and the client side, are happy with the result.

            So after we've had that sort of back and forth, then we can get to a final version of the report and sort of wrap everything up from there.  So that's the process on our end, that's sort of our A to B.  I think that that process would be similar to many other valuation providers.  But the unique perspective, at least at Morgan Stanley At Work is we're spending that hour on the phone with you on the kick-off call and we're willing to put in time afterward to make sure we're getting to a place that makes sense and that every - all parties involved in the process are comfortable with.

            And so that's sort of the process.  And in terms of the actual information that's necessary, I mentioned the cap table, a huge piece of it, and then as well we're asking for historical financial statements, we're asking for forecasted financial statements, the company's articles of incorporation which detail the rights and preferences of the various securities on that cap table.  And we're also asking for any recent company board deck or management presentation materials that provide sort of an update on KPIs or how the business has been trending recently.  And that's something that will be a discussion point on the management call that we can go through and make sure that we're connecting the dots in terms of the narrative that we're getting on that call and what we're seeing in the due diligence information.

            So A to B, that's sort of the process.  In terms of, I mentioned after the kick-off call we build the model and value the business, that can sound like a black box maybe to someone who's not working in this industry.  So, Steve, like in your mind, very maybe quickly, how would we - I'm a private company, I'm a start-up, how does a 409A provider value my business?  What do they care about?

Steve Liu:         Yeah, and the 409A valuation process is a bit different than others.  I think what's unique in it is that there - it's a two-step process.  The first step is we're ascribing a value to the business, but the second is we're water-falling that value down through the cap table.  Ultimately, again, as a reminder, this is to establish the strike price for your common option grants.  And so you can think of it as a two-step process.  For the first piece of it, for the business enterprise valuation, you have mentioned this before when you have a capital raise, oftentimes that's a trigger for a 409A. 

            And so thinking about the private markets, this is certainly like one of the very palpable touch points because as we're seeing the trend lines go down in terms of valuations and capital that's raised, that impacts the 409A because that becomes a benchmark of value for the company when they actually do this fundraising event.  And so oftentimes that's the most common use case where a client will come to us, they've raised capital, whether in an upmarket or down market.  That round will provide a benchmark of value that essentially frames up the valuation of the company.

            Outside of that fundraising event, we certainly pay attention to the company metrics.  And so if you look at a business for many of our start-ups, the first place to start is on the revenue side, looking at the growth prospects and risks, and really benchmarking that performance to other companies in the public markets.  And so that's another area where the public market volatility certainly impacts for 409A valuations because we're using public comparables as a proxy to benchmark against your start-up.  And then for more mature companies that have positive cash flow, we're looking at EBITA multiples.  And if they've got a forecast where we can dig deep into, you can start to get into discounted cash flow analyses.  So there's a variety essentially of ways to triangulate value for the business.

            And then from there, we get into the allocation of that business value through the cap table.  And that part gets a little bit more on the black box side.  Suffice it to say that we use something called an option pricing model that assumes a certain future value for the company and that gets water-falled down the cap table.  And the ultimate goal really of that exercise is to get to a value for your common share.  So, to your point, there's a whole process around this 409A valuation.  And on the management call, there's certainly interaction.  And you spoke to it a little bit about, I think for our clients and for our start-ups, certainly, they want to have a live dynamic conversation with us around the valuation.  So I guess from the standpoint of the client or the founder, how much feedback are they able to provide?  And what - how does that get considered in the 409A evaluation?

Sean Sutton:     Yeah, absolutely.  So I mentioned that sort of the end of the process is one, specifically for us when we send that draft, we're happy to take feedback from the client, the company that we're working with.  And so they have the ability to provide feedback in the terms of, oh, maybe we were too aggressive selecting X, Y, and Z assumption, and actually, when we've gone back and revisited our forecast, we found some areas that we needed to change.  And so potentially we need to re-implement a new forecast.  Potentially that means we're just making adjustments in other areas of the analysis.  And there are a number of assumptions that are basic in the model that are basically supported by management's guidance.

            And so the management has the ability to sort of discuss that guidance with us which feeds into how we're selecting some of those assumptions.  And so at Morgan Stanley, the way we run our business, we're happy to take that feedback and incorporate it into the model.  And this topic of am I allowed to provide feedback?  You're certainly allowed to provide feedback, but it's one of those things that can sort of lead into a common pitfall we see which is potentially the client or the company being too involved in the valuation and potentially leading to an over-engineering of your valuation.  So can you talk a little bit, Steve, about how, ultimately, we - I'm a founder, I'm granting equity to my employees and so the lowest strike price is better and so that leaves the most upside for my employees.  But is that always the case, like is lower always the best option for those grants?

Steve Liu:         Yeah.  And we're living in an interesting time, certainly.  I think if you look at, again, the private markets and how the trend lines are going, that you would expect to have a lower valuation.  But I think some of it goes to the fact that the 409A is supposed to be an independent exercise.  And so we certainly want to be asking the right questions and taking into consideration the perspective of the founder, because they certainly have an understanding of the business that runs so much deeper than what we could possibly have.  But the independence is key.  And then the second really goes to what I mentioned previously around what you're trying to select in the valuation provider and the fact that this is a compliance exercise.

            And so there's a whole framework around how a valuation should be performed.  And it goes to the assumptions and how reasonable they are and whether it really makes sense.  I think what was interesting as we've been going through this market volatility, we had, as you might expect, regulatory guidance.  And one of the bodies, the International Valuation Standards Council, IVSC, I believe, they - it was interesting to read through some of their guidance, one of which spoke to what you have mentioned around over-engineering maintainable earnings, or another way to put it is are you really just overemphasizing short term risk?

            And then another comment they made which I thought was very timely was just got at the fundamental purpose of a valuation.  And their comment was that the purpose of a valuation is not to stress test a valuation to an extreme case, which in other words is just use reasonable assumptions.  And this is where having that independence, having sort of a provider that has a broad experience, has deep experience, and can bring that perspective, can also kind of work well and complement what the perspective the founder brings to the table.

            And so I think it's a dynamic conversation that happens and one where we need to be careful.  Because the other piece, the compliance piece, which I will bring in, is if methodologies are used for the valuation of the company that are not approved and lead to a lower value, that creates all sorts of issues down the road.  And so it's about having a coherent valuation that makes sense with reasonable assumptions that take into account all perspectives.

Sean Sutton:     Yeah, and our job is to understand which assumptions that we should stress and which we shouldn’t.

Steve Liu:         Yeah, for sure.  And this is what makes it a subjective exercise.

Sean Sutton:     Yeah, exactly.  And switching or sort of on a similar tangent or topic, lower valuation than my prior 409A, should I reprice my options?  Like we hear that a lot in the market right now, folks getting repriced options considering it, should they, should they not?  What's your perspective on that?

Steve Liu:         Yeah, the interesting thing about the 409A is it's a bit of a lagging factor.  To your point, there's a safe harbor of 12 months and so what we saw 12 months ago certainly is very different than what we're seeing now.  And what I had mentioned about the water cooler talk with CFOs, many CFOs that we were talking with last year, it was on their radar screen, they were thinking about repricing.  But in large part, there was not a lot of activity on that front.  As we're coming into the new year, activity has certainly picked up.  If you talk with our colleagues on the cap table side, they're seeing a lot more activity.  And so I think this is a broader conversation ultimately that you have to have.

            One thing to keep in mind on repricing is it typically is a one-time event, so you really have to be careful around repricing.  Our general guidance has been like if you're seeing your valuation dropping 20% to 30%, that's the time when you should be having these conversations.  But again, I'm going to go back to the regulatory guidance, which is how much of that short-term risk should be considered in the valuation.  How much of it is impacted if your exit is five, seven, nine years away?  And so this goes, again, to your point around over-engineering your valuation that might lead you down the road to repricing.

            But just remember that the repricing, once you do it, it's permanent.  And so you need to be sure about what the reasons are behind it.  So I know one favorite topic of ours is the auditors, and you've had plenty of experience with them.  We're certainly not the only people who have a say in the valuation, the auditors have a very healthy say.  So maybe you could speak to the process and how they play a role in the 409A.

Sean Sutton:     Yeah, and this is definitely one of the common pitfalls and why we touched on selecting a vendor and making sure that vendor has experience navigating audit processes.  So that factors into the valuation when your company has sort of matured and you're sort of like mid to later stage and you've brought on auditors to take a look at your financial statements.  Eventually, those auditors will be interested about the 409A, and they'll want to review the valuation, make sure that what we're doing is compliant, and we're following subjective practices.  We haven't been too conservative or too aggressive in any area.

            And so basically at that point, it's the auditor's turn to ask their 21 questions, and their stress testing the valuation, both from a theory perspective and a quantitative perspective, making sure that the model that we're producing is running function is actually functioning correctly, and then making sure that everything we've done follows sort of approved valuation theory.  And so once your auditors get involved, they ask their questions, we have a back and forth with them, and hopefully, we get to a place where they're signing off on the valuation and saying, hey, we're comfortable with everything that Morgan Stanley did.  This thing is good to go. 

            But there's situations where if you're using maybe a provider who doesn't have audit experience or maybe there was some over-engineering of the valuation in the back and forth on the management side.  And your auditors do not accept the valuation.  And so now you've got a compliance headache of do we go back and get another 409A?  We've already issued options at this strike price that they're not accepting, do we not need to reissue those options?  What do we do?  And so those are compliance headaches that ideally we're avoiding, and ideally, your company is able to focus on growth and execution and not compliance 409A-related issues.  So that's sort of the audit process.

            And on the Morgan Stanley side, we have a ton of experience successfully navigating those audit interactions, and we think that's another unique piece about the practice that makes us an easy choice for folks, is that we'll make that process as smooth as possible for you.

Steve Liu:         Yeah.  And I think to your point to while the auditors are on the other side of the table and they're questioning our work, it's also a partnership that we have with them.  Because their goal is the same goal that we have, which is to have a valuation that makes sense, a valuation that will stand up to the scrutiny. And they have the client's best interest at heart.  And so to have that perspective coming in, I think, allows us to digest their comments and to make sure that we're valid that their comments are incorporated into the 409A.  So it can be a very healthy process at the end of the day.

Sean Sutton:     Yeah.  And when you - when we have those big four relationships where we're able to collaborate on some of the decisions we make in the valuation which makes the process smooth at the beginning and smoother in the end, and then smoother on the client side, which is a win-win for everyone.

Steve Liu:         Yeah.  Absolutely.  I agree with that.

Sean Sutton:     Awesome.  So I guess switching gears, and this ties back into sort of what you were mentioning at the top when we're thinking about the venture market and the state of that ecosystem today, one of the pieces we're seeing or not seeing is secondary transactions, tender offers, and sort of the impacts there.  And we hear we hear a lot from clients like, hey, we're thinking about doing some sort of transaction, does that impact my 409A?  Is that something I need to consider?  What do you have to say on that topic?

Steve Liu:         Yeah.  And certainly in the past few years, secondary transactions, tender offers, we've seen more of them and earlier on in a company's life stage.  And if you think about it, the IPO market's seized up, private markets, they're going through their own turmoil that the runway to an exit is being extended out further and further.  And so a secondary tender offer really provides a great way to reinvigorate employee morale, to incentivize employees to provide a measurable amount of liquidity to employees during a volatile time.  Now, of course, the tension is that when you look at a secondary or tender offer, oftentimes there's a pretty wide gap between your 409A valuation and your transaction price.  And that's because for a tender offer, there's a bit more perspective in terms of the value of the company whereas the 409A really is a snapshot of how the company exists now and bakes in a lot more risk.

            So, that being said, we could probably have a whole workshop on 409A valuations and secondaries.  This is where I'm going to pull the plug for our tender offer workshop.  So if you are curious around the subject, I think you'll get some great insights around this.  But if I could offer up just a couple pieces of advice.  One is you need to plan ahead.  Secondaries, tender offers, these are not things that should be planned in a vacuum.  You need to have a very broad conversation with your investors, with your lawyers, with your auditors, with your valuation providers.  And the key to that is to get alignment, alignment on the impact of that transaction price on your 409A valuation, and to get consensus there.  That's going to be really important.

            And the second piece that - is to plan ahead because how you structure the transaction, how you time it, who you decide to be your buyers and sellers, all that is dynamic in terms of how it impacts the 409A.  And so it really is to your benefit to plan it in advance and have those conversations as you're thinking about your next 409A valuation and perhaps also doing a secondary or tender offer.

            For any tender offer that's being done within three years of an IPO, that's subject to public disclosure.  So just keep that in mind as you're planning ahead, is that the last thing you need is to have some hiccups in the way that the secondary was transacted and then that becomes a speed bump to your IPO process.  It's the last thing that you would want.

Sean Sutton:     Yeah, absolutely.  And at Morgan Stanley, we have a whole team dedicated to transaction readiness for those folks that are able to plan ahead if that's something they'd want today.

Steve Liu:         Yeah, last year was a busy year for them.  They transacted nearly $4 billion in secondaries and tender offers.  So we have a team of experts that are ready to help out.

Sean Sutton:     Awesome.  And again, for any of the audience who's interested in learning more about tender offer secondaries, we have another workshop coming up soon.  That will be an entire session dedicated to the topic.  So more information to come there if you're so interested.  But from Steve and I, that wraps up our workshop today.  I think we covered everything we wanted to cover as far as 409A goes.  Again, tune into our next session.  And just to reiterate, if there are any questions that we missed that we didn't cover that you'd like to get some more context on, send those in, submit them.  We'll make sure to address them on a one-to-one basis and get those answers out.  And yeah, thanks, Steve, thanks for your time.

Steve Liu:         All of your time, Sean.

Sean Sutton:     Thanks for your time.

Steve Liu:         Thank you.

Sean Sutton:     Appreciate it.