2 posts categorized "May 2009"

Pricing Stock Options: Who’s Doing 409A Valuations These Days?

Let’s start with the assumption that we all agree startup technology companies should set the exercise price for stock options at fair market value (“FMV”).  There are board fiduciary, investor sensitivity, employee fairness and company morale reasons for this.  But the main reason we all aim for FMV--and the main reason we need to get FMV right--is to avoid tax problems.  We don’t want the issuing company or the option recipient to face higher rates, earlier or phantom tax recognition events, or stiff penalties.  Any of the foregoing parade of horribles can occur when options are priced at less than FMV.

In recent years, a prevailing practice has been to engage a professional appraiser to give a "409A valuation” of the company's currency for stock options (almost always voting common stock).  The practice arose in response to some proposed Treasury regulations, now final, that created a "safe harbor" against possible adverse tax consequences and penalties in certain situations where stock options might be found to have not been priced at FMV.  (Fenwick and West attorney Tahir J. Naim has written a superbly concise summary of these “409A “requirements.)  In response to these IRS regulations—even before they became final—a cottage industry of "409A appraisers" sprung up; prices charged were initially cheaper than those of traditional valuation experts, but crept up as most of the startup tech industry followed the practice.

Industry practice is currently in flux right now.  Generally speaking, early stage companies that are not venture backed are by and large not hiring independent valuation firms and instead are determining FMV in other ways.  Venture backed companies, on the other hand, still appear to seek the extra comfort of an outside appraisal (depending on your point of view, this reflects an appropriately professional prudence, little different than insisting a startup purchase D&O insurance; or else it reflects an aversion to exposure of firm members who would appear to be qualified, under 409A, as persons “with significant knowledge and experience” at valuations). 

As Davis Wright attorney Joe Wallin points out on his firm’s startup blog, third party appraisals are not required.  At the same time, a formal valuation may be better at shifting the burden to the IRS to prove that a particular valuation is not reasonable.  Prices for such appraisals, at least from the “cottage industry” shops and programs, have come down now, within a range of from $3000 to $7000 (some of these providers will commit to doing annual updates at a lower rate).  That’s still a lot for most startups to spend these days.  And there’s also a question as to whether some investors will respect valuations from some of the lower end providers.

On the other hand, for companies that lack internal resources (either from within management, or among members of their board of directors or advisors willing to take on the task) to perform a FMV analysis, it may make sense to “outsource” the job.  And once companies have significant revenue, or any kind of recurring profit, it strikes me that a reasonably priced outside appraisal begins to make much more sense.

I’ve sought and gotten feedback from several trusted colleagues and former colleagues on this point in recent days.  Here is a quote that basically sums it all up; this from a very experienced CFO I have worked with at two companies:

“I think the scattergram of board/company philosophies re: 409A compliance is pretty scattered.  My experience continues to be that “higher” profile VC firms (certainly those with Sand Hill Road addresses) have a lower risk tolerance and greater desire to go by the book – annual valuations with periodic interim updates – than the lower profile VC firms.  The big boys don’t care what it costs, and have a relatively short list of valuation providers that they’re comfortable with.  Same dynamic with law firms, although more lawyer vs. firm centric.  That said, compared to two years ago (and even a year) I think the focus is off this issue and onto other more pressing business issues by virtue of the passage of time.”.

“New Internet” LLCs

Some “New Internet” entrepreneurs who don’t foresee needing a ton of capital are now organizing new ventures as limited liability companies (“LLCs”).  The fact that this is happening may be related, in a way, to the economic depression, and probably reflects some of the ways entrepreneurs are re-thinking how best to capitalize and run startups.

The LLC form of entity has been around in Washington nearly as long as I have been practicing law.  It’s used frequently in real estate, from financing, to development, to management of income-producing properties.  But, by and large, the LLC has not been a suitable vehicle for tech startups that utilize venture capital.  Reasons for this are many, including the lack of settled law; and the disadvantages are only compounded when you cross state lines, as states treat LLCs inconsistently.  Not so with corporations (not really). 

I used LLCs first in the 1990s to form small, company-specific early stage investment funds.  The LLC form was amenable to the management of very specific investments.  For instance, you could set up capital call provisions to deal with the funding of potential exercises of warrants, and you could provide for separate classes or accounts to deal with follow-on investments that might occur in proportions different from the first round.  (These days, I and my colleague, Bob Muraski, sometimes use a Delaware series LLC to accomplish similar ends.)  In certain situations, you did not want the complexities or default rules of a limited partnership, and the LLC let you tailor your own rules of governance.

Even back in the day, an entrepreneur would occasionally suggest that we consider organizing a new tech venture as an LLC.  As recently at 18 to 24 months ago, though, I would typically talk him or her out of it.  You’ll close yourself off to venture capital firms, I’d say; people won’t understand your units of equity; fiduciary duties will be less clear, or will have to be drafted; legal costs will be higher.  (One entrepreneur once told me he understood a certain acquisitive software giant preferred to acquire LLCs.  That prompted a call to a former colleague, who then oversaw the giant’s M&A; of over [number between 50 and 100] deals, he told me, two targets had been LLCs, and both were royal pains to do due diligence on.)

I still think the corporate form is right for most startups.  You have to have a unique set of circumstances to opt out of the paradigm that is understood and accepted by most serial entrepreneurs, most investors, most executive talent, and the rest of the players in the eco-system of a developing company.

But an LLC can be a good structure for some entrepreneurs and their backers to consider.  If the venture is to be self-funded, or the need for outside capital is modest and the deal does not need to be syndicated widely, an LLC could present advantages that might be entertained before filing articles of incorporation.  I’m finding LLCs to be particularly flexible in dealing with complex or unusual affiliate relationships, where default corporate opportunity demarcations may not be appropriate.  Tax-wise, the LLC may also make more efficient use of short term losses, while not having some of the disadvantages of a corporation making an S-election.

I may report back with some brief observations on the organizational characteristics of some of these “New Internet” LLCs.  Meantime, please let me know if you have any thoughts about LLCs.

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