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409A valuations

I've recently hired a first employee, and need to put together a stock
option program. Under section 409A of the US tax code (
http://www.startupcompanylawyer.com/2008/01/19/what-is-section-409a/), I
need to assign a "fair market value" for the stock.

Does anyone have experience or advice in setting a valuation? Most of the
sources I've found online suggest hiring a professional firm, which appears
to cost $10,000 or more. We're early stage -- no revenue as yet, no outside
investment -- and would prefer to keep things simple and inexpensive.

Thanks,

Steve

9 Replies

Adam Geller
1
0
Adam Geller Entrepreneur
education technology explorer

Hi Steve,

Much like an offer letter would state the options upon approval by the
board, I think your agreement can state the options upon adoption of a
stock option plan.

Here is some language intended as an example and not to be construed as
legal advice. Check with your lawyer!

As the only consideration due Consultant for Services, Consultant shall
receive:

   - Options to purchase XXXX shares of Company common stock, as currently
   constituted, upon adoption by the Company?s Board of Directors (the
   ?Board?) and its shareholders of an equity incentive plan (the ?Equity
   Incentive Plan?).  Such options: shall be for Consultant?s own account and
   not for further distribution; shall be subject to approval and pricing by
   the Board; shall vest over 4 years, with 25% vesting on the one-year
   anniversary of this Agreement and the remaining 75% vesting in 36 equal
   monthly installments thereafter, in each case, for so long as this
   Agreement remains in effect; and shall be subject to at-cost repurchase
   provisions, as well as to the other terms of Company?s Equity Incentive
   Plan and the applicable form of Stock Option Agreement (to be executed by
   Consultant).
   - other points of your comp agreement

================
Adam Geller
ahttp://www.edthena.com

Tom Huntington
1
0
Tom Huntington Entrepreneur
CEO & Co-Founder of Windshield

Hi Steve, My comments below come with the same caveat that this is not qualified legal or tax advice.   Options should be granted at-the-money, which means that the strike price of the option = fair market value at the time of the grant.  If this equation doesn't hold true and the strike price is significantly lower (e.g. strike price of $0.05 on a stock worth $0.10), then you are effectively giving the employee taxable comp now which the IRS wants to know about.  The 409A valuation is intended to document the fair market value for this purpose. Since most companies hire employees (and submit option grants for board approval) throughout the year, it is cost prohibitive to conduct 409A valuations every time.  When the board approves the stock option grant for the employee, the board should also approve a fair market value for the stock as well.  This resolution should be reflected in the board minutes.  Convention for private companies is to conduct a 409A valuation at least once a year, and more frequently if there are significant events like fundraising. The market for 409A valuations has (thankfully) gotten more competitive over the last few years.  You should be able to get one for $5,000-6,000, maybe even as low as $4,000.  For a high quality, competitively priced valuation, check out Scalar Partners in San Francisco.  Depending on where you are, local consulting CFOs may do it for less. As Adam points out, you'll need a stock option plan before you can make the grant.  I would focus on this first.  If the employee is amenable, you might consider deferring all of these activities until you have more employees and funding.  For incentive stock options, vesting can begin as soon as service to the company begins (employee start date), even if the grant date occurs in the future. Best, Tom

Tom Huntington
(781) 535-4818 M
tomhuntinghttp://www.edthena.com

On Mon, Dec 10, 2012 at 11:58 AM, Steve Newman <st...@scalyr.com> wrote:

David Crooke
0
0
David Crooke Entrepreneur
Serial entrepreneur and CTO

It just has to be demonstrably fair market, and at an early stage startup
the value in the stock is pretty hypothetical. In the early days of Convio,
I would decide it by the finger in the air method and approve it by board
vote, and we only changed it after a funding round.

Once you get close to public reporting (500 stockholders or IPO prep) then
you need professional valuations done, and adjust it more frequently, or if
there is a big event that increases the company value, e.g. landing a huge
reseller deal.

Rules of thumb I used:

1. Just after series A, strike price for qualifying ISOs of *common* stock
was 10% of the price VC's paid for their *preferred* stock. This widely
used number for VC backed companies reflects risk - don't forget that due
to liquidation preferences, the employee stock is worth zilch until the
company is sold for more than the VC's put in. We had one person who was a
part time consulting executive (retired after explosive IPO) who was paid
only in options[1], and at her request (I think) her options were priced at
100% of series A, she wanted to be conservative for personal tax reasons.

2. At series B, we did 20% of the new preferred price (company has more
money and is a surer bet)

and then a logarithmic taper, with both the preferred price and percentage
.... options issued close to IPO (don't forget you'll still be hiring, and
bonusing employees with new grants) should be at 90% of the subsequent IPO
price

[1] for options to qualify as ISOs and favourable tax treatment, the
recipient had to be demonstrably an employee of the company. I don't know
where that line is drawn but an accountant will.

On Mon, Dec 10, 2012 at 5:30 PM, Thomas Huntington <

Krassimir Fotev
0
0
Krassimir Fotev Entrepreneur
Founder of Peer Belt Inc.

Steve,

Yokum rocks!

The fair market value may not be that important if you are granting options under the Company equity incentive plan (if the company incorporated with one). Under the incentive plan, employees may purchase options below the fair market value.

I currently have the problem of estimating the fair market value of contractor options. They need to be issued at fair market value, because, well, he is not an employee and not a subject of the equity incentive plan.

There is regulations that restrict the amount of options purchased under the equity incentive plan. Anything above 10% of combined voting power across the different classes of stock must be purchased at at least 110% fair market value.

When I first bought my options in the brand new Peerbelt, it was determined the fair market value was $0.001 a share, so initially the options were really inexpensive.

The section in the Peerbelt's stock incentive plan dealing with Option Exercise Price (prepared by Yokum when Peerbelt incorporated) reads:

Option Exercise Price and Consideration.
(i) Exercise Price. The per Share exercise price for the Shares to be
issued pursuant to the exercise of an Option will be determined by the Administrator, but will be no
less than one hundred percent (100%) of the Fair Market Value per Share on the date of grant. In
addition, in the case of an Incentive Stock Option granted to an Employee who owns stock
representing more than ten percent (10%) of the voting power of all classes of stock of the Company
or any Parent or Subsidiary, the per Share exercise price will be no less than one hundred ten percent
(110%) of the Fair Market Value per Share on the date of grant. Notwithstanding the foregoing
provisions of this Section 6(e)(i), Options may be granted with a per Share exercise price of less than
one hundred percent (100%) of the Fair Market Value per Share on the date of grant pursuant to a
transaction described in, and in a manner consistent with, Code Section 424(a).

Let me know, if you come across a truly inexpensive way of figuring the fair market value. I will keep you posted as well.

Cheers,
-Krassimir

On Dec 10, 2012, at 2:58 PM, Steve Newman wrote:

> I've recently hired a first employee, and need to put together a stock option program. Under section 409A of the US tax code (http://www.startupcompanylawyer.com/2008/01/19/what-is-section-409a/), I need to assign a "fair market value" for the stock.

> Does anyone have experience or advice in setting a valuation? Most of the sources I've found online suggest hiring a professional firm, which appears to cost $10,000 or more. We're early stage -- no revenue as yet, no outside investment -- and would prefer to keep things simple and inexpensive.

> Thanks,

> Steve

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Max Avroutski
0
0
Max Avroutski Entrepreneur
eCommerce, Software Developer, Usability, Marketing & Product Creation consulting services.

I don't know if there is a legal code that would prevent using following formula, but it seems very simple to me.

1) You need to understand that "fair market value" is always wrong. There is no perfectly liquid market. You just need to be not more that 500% wrong about it.

2) "Fair market value" is whatever someone is willing to pay if you are willing to sell at that price at that time.

3) If you are wrong - then you are not wrong.

3a) If someone claims that you are wrong use the same exact manner that they use to prove that you are wrong to prove that you are right. They had used a lot of unscientific assumptions so you can use similar assumptions for your benefit.

3b) You can use science to battle their art of assumptions. You can value something higher or lower as you need at the timer that you need to back into what ever number you need by using "Observer Effect" from physics where when applied to  "Fair market value" would read:

"Evaluating fair market value changes the fair market value."
?- I maybe the first to say it so quote me. :)

4) FMV is fluid and changes with each event. You hired a good engineer - your FMV goes up XXX% based on your industry multiplier discounted by how far away you are in month from revenue and so on.

5) Fair market value formula could be simple or complex. One indicative formula is:

Inder Singh
0
0
Inder Singh Entrepreneur
Founder & CEO at Kinsa

We got ours through for $2500 and were quite satisfied.  The firm we used do hundreds of 409a's a year so we (an dour investors) felt assured that it was being done right. It was pretty painless and relatively quick. Let me know if you want a contact and I can provided.

Sent from my iPhone

On Dec 11, 2012, at 5:20 AM, Krassimir Fotev <kfo...@peerbelt.com> wrote:

Seth Kaplan
0
0
Seth Kaplan Entrepreneur • Advisor
Healthcare Technology Executive, Product Manager, Enterprise Architect, IT Strategist and Intrepreneur

Steve, your company is worth $5M.

You can send me a check for $5k or I'll take my fee in preferred equity.

Cheers.

-- Seth

On Dec 11, 2012, at 3:13 PM, Inder Singh <irsi...@gmail.com> wrote:

Steve Newman
0
0
Steve Newman Entrepreneur
CEO/Founder @ Scalyr

On Tue, Dec 11, 2012 at 2:15 PM, Seth Kaplan <s...@seth.org> wrote:
> Steve, your company is worth $5M.

> You can send me a check for $5k or I'll take my fee in preferred equity.

Steve Newman
0
0
Steve Newman Entrepreneur
CEO/Founder @ Scalyr
I'd been meaning to follow up on this thread, was finally prompted by another post.

Thanks to everyone for the suggestions. In the end, we wound up skipping stock options entirely and giving outright stock grants instead, with a buyback clause to achieve vesting. We did this primarily to avoid the expense and hassle of a 409a valuation. It also has a benefit for the recipients, in that they are much more likely to be able to get long-term capital gains treatment someday down the road when they are able to sell their shares.

Of course, this won't work for everyone. We are bootstrapped, and so we haven't had to set a high valuation on our shares for fundraising purposes. This makes it much more palatable to sell shares outright to our employees and gross them up for the purchase price.
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