Last year was a great one for startups. It was a record year for IPOs, valuations for pre-IPO companies skyrocketed and fundraising broke records.
But 2022 will be very different. Many of the companies that went public last year have seen their stocks plummet, and that misery is seeping through to the private market as late-stage technology companies begin to see their valuations plummet.
While no one can predict the future, lowered valuations are not as ominous a sign as they make out. Just as what comes up must go down, what is down will most likely go up again. But while things are spiraling downward, there is a unique opportunity for startups to lower their valuation.
Yes, reduce. Trying to maintain a valuation that is too high is not necessarily good for you. In addition, it can even harm the future growth of your company.
Re-evaluating your 409A now is the right choice for your employees, as their assets are not up to date with the rest of the market.
While it may seem counterintuitive, a lowered valuation can benefit your employees and your company’s recruiting efforts. On the other hand, a high valuation increases the cost of exercising or buying those stock options.
A lower valuation will lower those costs and make equity packages more attractive to new hires, especially in a job market that’s red-hot with recruiters vying for talent.
What is a 409A valuation and why is it important?
Stock options are given a specific price, the so-called strike price. The strike price will be similar to that of the 409A at the time the option is granted, and that will never change. What does change is the valuation of the company, which is reflected in the 409A valuation. This in turn has consequences for the fair market value (FMV).
When an employee starts exercising or buying his options, he must pay tax on the difference between his exercise price and the current FMV. That’s because the IRS counts the increased valuation of the stock as income, which may be subject to income tax or the Alternative Minimum Tax (AMT).
Many employees have a wait-and-see attitude with regard to their equity. Once they believe their company has “made it,” such as achieving unicorn status, they find it less risky to go ahead and buy their stock options.
For new hires, a lower 409A valuation will translate into a lower base cost of equity. This makes job openings more attractive, as a fall in valuation does not necessarily mean that the company will not have a healthy exit. For current employees, this means they can pay less to exercise their options and be better prepared for a potential exit.
For example, Instacart submitted to go public after announcing a valuation cut with the explicit message that this would improve the compensation packages for new hires.