with Steve Liu from Morgan Stanley at Work
Scenario #1: If a company experiences a significant drop in their 409A valuation, at what point should it consider conducting an option repricing?
Option repricing has certainly become a more common consideration, especially over the last year. Lower valuations brought on by COVID-19 have forced more private company leaders to consider repricing their shares, in order to provide greater upside to their shareholders.
While this can be a good strategy that signals long-term confidence in the trajectory of the company, companies should think about the long-term impact. For instance, you want to be sure that the company’s valuation is not likely to fall any further and that you have addressed the business challenges that led to the de-valuation in the first place. It’s important for founders to speak with their CFO, board of directors, and other leaders and think hard about how it will impact the long-term growth of the company.
Scenario #2: If a company allows unrestricted secondary trading of its shares in between or in lieu of liquidity programs, how can it minimize the impact on the 409A?
The short answer is that it’s very hard to predict or control the impact of unrestricted secondary activity on your company’s 409A valuation. Valuation agencies are placing greater credence on these transactions and the more frequent activity, the more likely it is to impact your next valuation. For later-stage companies closer to an exit, the impact of these transactions is going to be greater; and keep in mind that the SEC is going to be looking back 18-24 months at all of this secondary activity.
This is a big reason why more companies are choosing to conduct controlled liquidity programs, in order to exercise greater control over the timing, frequency, and cadence of secondary activity. Consolidating activity and timing it in conjunction with a capital raise can help control the impact on the 409A valuation, while also releasing the pressure for liquidity. If you start to notice trading activity picking up, that’s a good sign it might be time to run another tender offer.
Scenario #3: Is there a 409A valuation threshold at which it makes sense to switch from issuing options to RSUs?
Generally speaking, companies tend to switch from issuing options to RSUs when they reach later-stage valuations, or they are a couple of years out from an exit. The reason is that there’s lower upside for new hires, either because the amount of available options is too small or because the value of the stock is too high. In either case, RSUs may seem a more attractive option, particularly for senior hires brought in late into the company’s growth cycle.
Switching to RSUs can also make sense if option grants are “underwater” and the strike price is greater than the current value of the stock. The caveat here is that if the company expects the valuation drop is only temporary, options may still offer greater upside potential.
The final thing to note about RSUs is that they typically have single or double “triggers” which dictate when they will vest. For instance, there may be a trigger that says RSUs will only vest when the company goes public. As you start to think about switching over to RSUs, which you should really only start doing as you get closer to an exit, just keep in mind there are different ways to structure them alongside shareholder incentives.
Scenario #4: Company X decides to run a tender offer immediately following a capital raise where preferred shares were issued to investors. How might the mix of common and preferred stock impact the 409A valuation?
The impact of the transaction itself will vary depending on how close the tender offer is to the capital raise. That’s a big reason why companies choose to do a follow-on tender offer using proceeds from the fundraise – so that it’s treated as one simultaneous transaction.
As for the mix of common versus preferred, if a large portion of the equity is being transferred via the tender offer, it will definitely impact the 409A valuation. The extent of the impact will depend on the size, amount, and composition of the sellers, and information given to the buyers. You may also have a situation where a company allows investors to purchase common shares from employees but then convert them into preferred shares. So essentially, they’re buying common stock at the preferred price. In that situation, again assuming the transaction is happening simultaneously with the capital raise, it will have limited impact on the 409A valuation.