Avoiding 409A pitfalls | Carta

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today we will cover a general

introduction to 4/9 a and a review of

how to avoid common 4/9 a pitfalls

first let me introduce our panelists

Candis was previously a managing

director in the valuation group at Grant


she has over 12 years of valuation

experience Susheela is a managing

director and head of valuations at Carta

she is over 20 years evaluations

experienced and previously held a

leadership position in the valuation

group at PwC bob has over 15 years of

valuations experience and previously

held leadership positions in the

valuation groups at BPM and PwC

a quick review of our agenda we're going

to cover what is a four nine a valuation

and some history of the legislation how

to think about finding a qualified

valuation provider and some of the audit

implications of valuation some thoughts

on how to budget your time some thoughts

about how to decide whether or not your

valuation was reasonable and then we'll

conclude with a quick review of why you

may want to choose to work with cart

evaluations but before we get started a

quick word from our lawyers this

communication is on behalf of cart

evaluations LLC an affiliate of a shares

Inc DBA karda this communication is not

to be construed as legal financial or

tax advice and is for informational

purposes only this communication is not

intended as a recommendation offer or

solicitation for the purchase or sale of

any security Carter does not assume any

liability for reliance on the

information provided here in so susheel

we frequently get the question from

clients what is a four nine eight

evaluation and how does how did this

regulation come into effect okay Florida

a basically refers to a section in the

Internal Revenue Code the code number is

four nine eight and it's a section of

the IRS code that deals with deferred

compensation how did this come into


well basically our government took a

deep look at deferred compensation plans

after the Enron bankruptcy in the Enron

scandal over executive compensation

plans in 2000 and then the government

put in a number of regulations for

deferred compensation plans which went

into effect in 2005 and you know been in

our context section 409a applies because

option grants typically used as

compensation in startups is essentially

deferred compensation employees get the

options of a certain strike price and

then cash out sometime later got it so

what is a four nine evaluation exactly

well in our context

foreign any evaluation sets the fair

market value the fair market value

that's a tax word a fair market value of

a share of a common stock in a private

company is what a foreign idea valuation

is when options are granted at its fair

market value there's no tax liability to

the employee the date it's granted and a

foreign evaluation basically sets that

exercise price for the stock options

that are given you know in start-up

stock options are used as incentives to

attract and retain talent and these

options allow employees and others to

get some of the wealth created by a

start-up by getting an exercise price

and then later cashing out in an exit

event perhaps excellent Thank You Sheila

another question we frequently receive

is from our clients is what is safe

harbor can you walk us through what that

is meaning of safe harbor well safe

harbor provisions in the tax world mean

that if certain conditions are met risk

of tax penalties are reduced or maybe

even eliminated use of some safe harbor

practices creates a presumption of

reasonableness with the IRS that means

in the case of an IRS audit you start

out with with the presumption of

reasonableness in our context again in

foreign in a context there are a couple

of safe harbor provisions that if

followed will protect the board of

directors and the senior executives of a

company one of these is who does the

valuation so evaluation done by a third

party specifically a qualified

independent appraiser will help with the

safe harbor provision another one is is

a timely evaluation evaluation done

that's that's done at least once a year

for an ongoing company and whenever

there is a material event that changes

the value of the company typically in

startups material events referred to

financing events great thanks so much

another question is if if I'm working

I'm the CEO of a new startup when should

I think about getting a 409a evaluation

well many companies think about getting

a foreign an evaluation as they're

getting incorporated certainly as soon

as there are plans to issue equity

compensation to founders or employees

it's time to get a 409a valuation

typically corporate attorneys can help

with choosing the date of the valuation

many companies do a foreigner evaluation

even before any value is created as a

strategic move because the fair market

value will reflect the fact that there

is no value created in the company and

and so therefore that the strike price

will be lower at that time then sometime

later obviously when as the company

progresses and and this value created a

new new valuation will be done perfect

thank you so much - she'll assuming now

that a company's decided to get a four

nine a valuation Bob how a company think

about evaluating thanks Ben

so first and foremost you know you want

to make sure that as Susheela mentioned

the appraiser is independent of the of

the company and typically that means is

free of conflicts of interest and the

the foreign idea report ultimately will

contain certification to that extent but

you know for the purposes of the senior

executive at this point you know

basically it means that you want a third

party who's not related to the firm and

and unfortunately this also means that

you won't be able to to pay for the

services of the appraiser in equity like

a lot of startups tend to do the second

thing and this is a bit unfortunate is

that there are a lot of bodies out there

that issue credentials in in valuations

unfortunately there's no single body

that really regulates the valuation


unlike the you know the bar with the

legal profession or the AICPA with with

the accounting profession so looking at

Prazeres tends to be that akin to

looking at a bowl of alphabet soup

what you want to do is make sure that

your when you talk to a potential praise

or make sure that they have extensive

experience and doing valuations of all

types but but specifically with 409a and

that they they can point to experience

in ideally your your company's

particular industry or sector it's one

thing to have you know 20 years of

experience in valuing you know your

retail establishments but that really

doesn't help you very much if you're a

b2b software company so you want to make

sure that you're your appraiser

understands both the industry that

you're in at a macro level but also the

specific sub sector of the of the

industry that your company is competing

in so that they can fully reflect the

the opportunities and risks of of your

particular company you also want to make

sure that the that the appraiser has had

some you know broad experience and

taking evaluations through the entire

audit process we can talk a little bit

about the audit process in a minute but

taking valuations through the entire

audit process and defending them against

out with outside reviewers and that

ultimately they will stand ready to

stand by you about my entire audit

review process why is it so important

for a company's 409a

well first and foremost I just want to

point out that that you know valuation

despite what what a lot of people might

think is inherently a subjective process

and that subjectivity means that those

valuations are going to be subject to

review by outside interested parties

those parties could range from you know

accountants and auditors to the IRS and

ultimately if there is a successful exit

for for a company but

actually regulators like the SEC that

means that the valuations all of the the

inputs and assumptions and conclusions

contained in the valuation need to be

assessed and determined to be reasonable

with inputs that are that are sort of

obvious for example a risk-free rate of

interest you know those inputs are you

know pretty much you know unassailable

and and if you if you get the get get a

risk-free interest rate from you know a

database source that pretty much is it

because it's you know it's pretty much

published in The Wall Street Journal

every day other other inputs and other

assumptions are a little bit more

subjective and so you know the auditors

will do conduct certain procedures to

make sure that there's reasonable

support or those other you know

important inputs and conclusions

sometimes the credibility of the

appraiser certainly can help in that

process but ultimately you know you want

to make sure again that the that your

appraiser is experienced in working with

the the auditors or whoever the third

party reviewer is in defending the

evaluations throughout that entire

process and has successfully defended

their their work in the past and you

know what that ultimately what that

means is that you're going to be able to

avoid some of the penalties for a bad

analysis which can range from you know

financial penalties for for certain

violations of tax rules but I think more

importantly it helps you to avoid the

possibility of delays and getting you

know whatever objective it is that that

you want to accomplish done whether

whether that's you know sending out

documentation for board meeting or as I

mentioned before if if the company is

successful you know filing for for an

IPO perfect thank you so much Bob

once a candies once a company's decided

to they've selected a foreign a

valuation provider and decided to

conduct the analysis how much time

should have company budget for a foreign

a valuation that's a great question then

and I know it's something that clients

are always curious about and and the

answer is it really depends a little bit

on the complexity of the company um we

see a lot of early-stage companies

perhaps that have raised a series seed

or a series a round of financing those

valuations tend to be a little bit more

straightforward so they can usually be

turned around at key within 10 business

days as you have companies that are a

little bit later stage maybe they are

generating material revenue maybe

they've raised a series being round the

financing there can often be a little

bit more analysis that's required and

and that can take more in the ten to

fifteen business image and then of

course once you have companies that are

getting close to an exit maybe they have

an IPO or an acquisition in the near

term it may take a few days longer

because there's a lot more to consider

in that situation and more analysis that

needs to be done so it really does come

down to complexity and how much analysis

is required sometimes you know we also

see companies that have specific

specific issues that can contribute to

complexity for example here at Carter

we've been seeing a lot of companies in

the cryptocurrency space recently that

are issuing their own tokens and that

can require a little bit more analysis

on our part as we think through what the

value of those tokens should look like

certainly I tend to advise clients that

if you are getting within a month of

your foreign and expiring or if you're

getting close to closing a round of

financing you want to start thinking

about your foreign I may evaluation and

reaching out to your provider so that

they can get started great thank you so

much thinking about the process you walk

us through what the four nine evaluation

process looks like sure yeah it's

actually pretty simple and a little bit


because we have technology to support

our evaluations and we also post most

clients cap tables on our platform a lot

of clients also have their financials

connected to our platform so we have a

lot of the data already that is

typically requested when you're going

through a form and a process once a

client decides they want to get a 409

hang they can log into the platform and

submit a form and a request form and

that's going to have them fill out some

some things and provide some additional

information that we may not have such as

financial forecast and the updated

Articles of Incorporation and as well as

respond to you qualitative questions as

well such as you know how long it might

be into one exit once that forms filled

out a dedicated for my name analysts

will be assigned and the client and the

analyst will have a kickoff call at that

time the analyst will ask a variety of

questions about the company try to

understand how the company's been

pressing what the expectations for

liquidity event are etc once that's done

the valuation analysis would be

conducted the analyst may reach out with

any additional questions and then

deliver the report through the platform

the client can then go ahead and have a

review call at that point with the

analyst if they have any questions and

want to get some additional

understanding of the valuation report

once that's complete they can go ahead

and immediately start issuing options

through the platform

thanks so much for that um when once a

valuations delivered how can we think

about how can a company think about

determining whether or not the valuation

was reasonable sure yeah certainly you

know everything Bob said earlier about

selecting a qualified provider it's very

important that that's absolutely the

first step then I think once you've

actually got the form an evaluation

report it's important to sort of

understand the methodologies that go

into the valuation the most common

methodology that we see in foreign on a

valuation is something called the backs

off methodology and basically what this

is is when a company's had a recent

round of preferred financing there's

been a price established for bird stock

and that transaction can be used to

solve for what values implied for the

common stock so that that's what's

termed a backstop analysis and of course

other methodologies can be considered as

well but that's by far the most common

and I want to touch on it here too

because I think that it can be the most

difficult for clients to evaluate there

are some major assumptions that go into

a back solve

specifically term and volatility are

very important term in the back saw is

going to be how long before the company

expects to reach a liquidity event and

that's going to vary based on the stage

of the company etc another thing to

consider when thinking about term is are

there potential near-term exits that

could happen if the company isn't

successful and how can we wait those in

to determine sort of a weighted term of

what's most likely to happen company

next volatility is something that will

be considered typically you look to

public companies in the similar industry

as the company that we're evaluating and

look at the volatility of their stock

prices to make an estimate about what

makes sense for for the company finally

another equipment you'll see in the

valuation is something called the


lack of marketability or D long so

effectively what that is is a discount

that indicates that a share of common

stock is much less marketable or less

saleable than a share of preferred stock

because it has different rights and

preferences it tends to be a less

desirable class of equity to hold and

discounts for lack of marketability can

range anywhere from as high as fifty

percent in a really early-stage company

where there's a long term to exit to as

low as something like five to ten

percent if the company is right around

the corner from an IPO so that's just

something else to think about and

evaluate when you're looking at the

valuation report excellent thanks so

much Candis how can a company make sure

that their valuation analyst takes into

consideration all of the qualitative

information associated with their

business absolutely you know it's great

to sort of dig into the numbers and

think about all these specific

assumptions but we also really need to

step back to and think about the big

picture you know clients really know

what the story of their company is they

know what's happened over the past year

and you need to think about big picture

does this make sense if you had a great

year you really beat your forecasts and

did really well well you'd expect an

increase in your value and so that

should be something that's captured on

the flip side if you had a tough year if

you have to pivot in your product etc

and you might expect a downturn in the

valuation so certainly you want to make

sure you're communicating all those

qualitative factors to the analyst and

making sure they're getting accounted

for an evaluation fantastic thanks so

much turning back to Cecile and this is

an area where we very frequently receive

questions from clients as a as a sort of

hypothetical example if a company has

just raised a round of financing at say

one dollar per share of her preferred

share how should the company think about

what the price of the common stock

should be

oh I'll take that question because this

comes up all the time so when we do a

409a valuation we look at each class of

stocks separately you know the preferred

stock price is established usually in a

highly competitive setting with

management seeking to get the highest

possible price for their preferred stock

and the preferred stock has many

benefits that the common stock does not

have these benefits may include being

first in line to get the assets in the

event of a liquidation a big one

conversion options sometimes dividends

many other benefits such as control of

strategy perhaps rights to be on the

board so if a company raises funds as

you said with preferred stock and and as

established a certain price the value of

the common share is many many times a

small percentage of the preferred stock

price because the preferred stock has

many advantages that the common stock

does not have exactly what the Delta

should be that is why people like us do

the analytical work in our practice

valuation of early-stage companies is

based on an analytical framework a

framework of methodologies set up by the

AICPA and it discusses the appropriate

methodologies to be used based on the

stage of company and we use that but the

specific question aren't here should I

expect the common stock value to land in

a tight range as a percent of the

preferred should my common stock always

be between 20 and 30 percent of that

price well it's not that simple the

price of the common stock is going to

vary based on the percentage of

preferred based on how big the capital

raises relative to what what has already

been raised some specific rights and

preferences some risk characteristics

sometimes the stage of development you

know something that we can say with

confidence is as a company gets near an

exit event like say an IPO the value of

the common and the

will will converge but in fact there are

no hard and fast rules on where a common

stock fair market value should should

land relative to the price of preferred

there are rules of thumb out there but

they are just rules of thumb they are

not analytically derived and so there's

no there's no range that we kind of

depend on excellent thanks so much

moving to our last slide and just to

give an overview of why clients may want

to consider working with cart

evaluations basically because carta

maintains the core asset required for

evaluation specifically the company cap

table and the rights and preferences

associated with each share class we can

provide a for 9a valuation more

efficiently more accurately and less

expensively than traditional valuation

providers so that's why our valuation

clients tend to work with

so much everyone for joining our webinar

really appreciate your attendance if you

have any further questions please feel

free to reach out to me at Ben dot

Hanley at Carter comm thanks again