For most high-growth companies, the ability to offer equity to founders, employees, consultants, advisors, directors, and others is often critical for success. Equity-based compensation can align interests, keep everyone motivated to ensure the enterprise’s success, and allow companies that can’t afford to compete on salary to attract top-quality talent.
However, to use issue stock, options, or other equity-based securities, you will need to know how much that equity is worth, which can pose important timing and structuring considerations.
When do I need a valuation?
Any time a company undertakes a transaction involving equity, it will have to determine its value. Whether the company is issuing stock directly, options to purchase stock, restricted stock units, warrants, or other securities, that is true.
Company startup
When a company is first formed, one of the initial organizational steps is to issue stock. Just like any other time stock is issued, the issuance of stock at formation requires a valuation. Fortunately, since there is often no practical value at the time of formation, this is the one time in a company’s life that the valuation process is simple. In practice, nearly every company values its stock at startup with a minimal value.
This window for issuing stock with minimal value, however, quickly evaporates in a high-growth company.
Blackout windows
Any time there is an event that might materially impact the valuation of the Company, the Company has to stop and determine a new valuation before any additional stock can be issued. The list of events that might impact valuation is long and includes:
- receiving a term sheet for a financing
- borrowing a significant amount of money
- launch of a new product or service
- achievement of significant research or development milestones
- receipt of clinical trial results
- significant revenue growth
Fortunately for a high-growth company, such events are common and can happen frequently. Unfortunately for a company that wants to issue stock or options, these events can prevent you from issuing stock the company stops to re-determine its valuation. In the case of an event like the receipt of a term sheet, it may take several months between the receipt of a term sheet and the transaction completion. Such lengthy blackouts can be hard to plan around. If the timing is not anticipated and handled with care, they can lead to frustrated or angry founders, employees, or advisors.
Why do I care?
If a company does not use care to determine its stock valuation, the consequences can be significant. On audit, if the IRS disagrees with the price, both the company and the recipient of the stock will be subject to penalties and interest. Moreover, and more practically, stock valuations are heavily scrutinized in connection with any professional investment transaction. Failure to determine valuations appropriately can derail an otherwise promising financing opportunity. Later in the company’s life, when companies financial statements are scrutinized in connection with an audit, M&A transaction, or public offering, historical failures to appropriately determine valuations can result in significant restatements of financial statements, negatively impacting exit valuations.
How is valuation determined?
Fundamentally, valuations are determined by the company’s Board of Directors. Practically, however, board members have a fiduciary duty to engage the advice of financial and valuation experts to support their valuation. As a result, the best and most secure way for the board to determine valuation is to hire a third-party valuation firm. Usually, these are marketed as “409A” valuations, named after the IRS tax provisions that penalize taxpayers who get valuations wrong. Fortunately, however, if a valuation is done correctly and in accordance with IRS and industry best practices, it is relatively immune from challenges later.
Short of a third-party valuation employing best practices, any valuation determined by the board using any other method is subject to challenge. The less rigorous the method used, the more open to challenge.
Observations and Conclusions
At Inceptiv Law, we have seen clients use valuation methods of various degrees of sophistication. Sometimes it’s the cost of the valuation that is seen as prohibitive. Other times it’s a worry that the valuation returned by a third party will be too high. In reality, the cost of getting a valuation will be a fraction of the cost of defending a sub-standard process, whether to the IRS, a potential investor, a potential acquiror, an underwriter, or an auditor. On top of that, the soft costs resulting from an inadequate process, which may derail or devalue a transaction, financing, M&A, or IPO, are often unquantifiably significant.
Concerning valuation, ultimately, it is what it is. Running a substandard process to get a lower valuation, hope nobody will notice, is not a recipe for success. More pointedly, the stock value in a high-growth company comes from its growth, not from its present value. If you believe that the valuation will go up, the starting point will be relatively irrelevant. Companies that focus too much on current value are losing sight of the bigger picture. Focus on the upside you are creating, not on where you are today, and you are much more likely to get there.
With an understanding of the rules and some planning of your capital table, you can avoid most of the morale and perception issues that come from delays in the grant of stock or options and surprises about the price of stock or options. At Inceptiv Law, we always recommend addressing stock price and timing issues through education and planning, not shortcuts.
Inceptiv Law
Seek out and establish a relationship with legal counsel early in your company’s journey. At Inceptiv Law, we are experienced in providing legal advice and business resources to high-growth companies. Contact us through our website to schedule a consultation. We can also be reached at 858-208-0193.
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