409A Valuations — Are You Pricing Your Options Too High?

Start-up CFOs are fast realizing how early stage 409A valuations completed by quick cookie cutter, ‘textbook’ approach often result in inflated option prices and disgruntled employees. Naturally, a 409A valuation has to be more than just compliant; it has to be fair for your employees.

Setting a price for stock options before the advent of 409A regulations was thumb-rule driven, an inconsequential 10-minute exercise in start-up Board meetings where it was often agreed at about 5%-10% of the latest preferred round. The need to conduct independent third-party valuation under 409A provisions changed this approach. Albeit, significantly burdening the cash-conscious start-ups.

Valuation as a discipline requires its practitioners to indulge in both art and science to form a judgment.  However, of late, pricing pressure has pushed several firms to gravitate quite heavily towards a template-driven, cookie-cutter approach to using the statistical Option-Pricing model in 409A valuations. While much lower fees, quick turnaround for 409A valuations seem good news for start-ups, several CFOs and law firms have explicitly expressed concerns over common stock being priced as high as 25%-35% of preferred issue price for Series A companies. 

Such valuations reports often land CFO/Controllers in soup during board meetings as “they don’t make business sense”. Considerable time is lost in re-engaging with valuation analysts to re-negotiate an acceptably lower value. Even if these valuations pass through board review, the worse yet easy to overlook situation is the impact of inflated stock option price on employee morale.

The Option Pricing model, which is used to value common stock, often runs on a few and easy-to-develop assumptions. However, it usually produces results that are found to be counter-intuitive to how investors and CFOs see risks being factored in while early start-up investing within the VC ecosystem. The Option Pricing model is built on the log-normal curve premise—that assumes near equal probabilities of success and failure—which in turn is quite unlike the risk profile of investing in early start-ups.

Valuation professionals are quite aware of such fundamental deficiencies of Option Pricing models for application in start-up valuation. Moreover, AICPA valuation guidelines do not bar valuation analysts from using hybrid (and a tad more complex) models to reflect the risks of investing in subject securities at given stage in an early start-up. However, valuation consultants generally avoid investing their time and effort to research and analyse data to build such hybrid models, as most start-ups can hardly afford such exercises.

There isn’t a debate on whether such boiler-plate 409A valuation reports are compliant or not. The bigger question to ask is whether such reports are fair to employees receiving stock options at the inflated prices thrown up by such reports. Let’s take an example of four companies in different industry sub-sectors (refer to the next table), each of whom has received $5 million of Series A funding at a post-money valuation of $25 million.

If a valuation expert applies the plain vanilla Option Pricing model to each of the four cases with the given set of volatility and exit assumptions, the results for common stock FMV shall vary between 30% to 35%. However, if a few pertinent questions are asked to dive deeper, one may realize how risk profile of investing in these ‘seemingly similar’ start-ups is so divergent.

Some of such questions should be:

• How much total funding an average successful start-up raises before exit in a biotechnology space compared to a company in SaaS business?
• What is the median number of years an average successful start-up takes before seeing exit across different industry verticals? How exit patterns have changed?
• What is the time-horizon of Series A companies to raise the next round of funding across different verticals?  What is the successful follow-on investment rate (to Series B)? 
• What is the typical cash-burn rate for start-ups in different industry verticals for Series A stage companies?

The table above highlights these factors for each of the four companies. Clearly, the assumptions of Option Pricing model can largely miss capturing such considerations. A well-thought hybrid valuation model, which uses multiple scenarios of success and failure built on key milestones of dynamic business probabilities, can help better capture the impact of several key risks and result in a common stock value that more appropriately reflects the risk exposure of a common shareholder.

While such hybrid models do increase the subjectivity in the valuation process, it is better to be vaguely right than precisely wrong. The real skill of the valuation analysts is to weigh in their research and report writing skills to craft the thesis in valuation reports to keep the common stock value rightfully low, convincing enough for companies, employees as well as auditors.

We do not contest the legality or regulatory compliance of various valuation models adopted by several 409A valuation firms. We, however, do like to repeatedly ask whether such valuation models are fair, considering the risks and challenges of inflated stock option prices CFOs may encounter.

We, therefore, believe that as a saying goes—“It is wise to pay too much, but unwise to pay too little”—start-ups and their attorneys would do better to weigh in these pertinent points while selecting their valuation service partners.