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Questions raised about professional valuations of corporate stock


Source: The New York Times | DealBook, March 8, 2017 article

Valuation Shell Game: Silicon Valley’s Dirty Secret

Street Scene


The 409A valuation allows hot, privately owned technology companies to issue common stock or stock options to employees at a low price while selling preferred stock to outsiders at a higher one. Max Whittaker for The New York Times

You want to know the dirty, little secret of Silicon Valley? It’s called the 409A valuation.

Yes it’s obscure, and yes, it’s a little bit technical. Here’s how the process works: In order to attract and to retain high-powered employees, high-flying tech companies want to issue them common stock or options. To do so and to comply with Internal Revenue Service rules, they need to obtain an independent, third-party valuation of the company.

This type of valuation allows hot, privately owned technology companies — like Uber, Airbnb or Nextdoor — to issue common stock or stock options to employees at a low price and, at the same time, or nearly the same time, sell preferred stock to outside investors at a price that is often three or four times higher. It’s also a way for company founders to control the market for the stock of their private companies while rewarding themselves and key employees with cheap shares that seem instantly worth a lot more than the price at which they were issued.

Failure to comply with section 409A of the tax code would make employees receiving the stock grants personally liable for immediate taxation on the excess value embedded in the stock or options, plus a 20 percent penalty tax.

But of course the valuations are costly and wrapped in complexity. The many firms that do the 409A valuations are able to charge around $50,000 a pop for them depending on the work needed to be done to value a company, and they often prompt discussions between the appraisers and the company’s auditors, raking in still more fees for all involved. Because companies are often issuing stock — say, when new employees are hired — the 409A valuations get done several times a year.

The result is reports with curiously precise numbers that often have a dubious practical value.

“So you have two companies, paid by the hour, arguing over false precision,” Bill Gurley, the general partner at Benchmark, a leading Silicon Valley venture capital firm, texted me recently. Mr. Gurley, whose firm has invested in Nextdoor, disdains the 409A valuations as a wasteful exercise. He calls the valuations “quite precise — remarkably inaccurate.”

There are all sorts of supposed valuation experts — such as eShares (“the world’s largest provider of independent, audit-defensible 409A valuations”), or Silicon Valley Bank (“high-quality, audit-defensible valuation reports to support you through a liquidity event”) or Duff & Phelps, which claims “deep expertise” in 409A valuations — and are all eager and willing to provide the work that is legally necessary to justify the granting of stock or options to employees at a price well below the price at which the companies are selling stock to outside investors.

Bill Gurley, the general partner at Benchmark, a Silicon Valley venture capital firm, has called valuations, “quite precise — remarkably inaccurate.”  Peter Earl McCollough for The New York Times



(One way the lower valuations are justified for employee stock grants is because they are of common stock, not the preferred stock that often gets sold to outside investors. There are other reasons to justify the higher price, too, such as board seats and access to financial information.)

But valuing these private companies is often a difficult and imprecise exercise, even though the experts can come up with a number that feels real. “The thought that ANYONE can be precise about the value of a private company to the second decimal place is preposterous,” Mr. Gurley continued. “No one that is properly trained in finance should have ANY confidence in such an exercise. As such it’s become a bureaucratic waste of time.”

The valuations also give the founders of technology companies extraordinary control over the market for the private sale of company stock.

Whether employees realize it or not, the stock the company grants to them often explicitly prevents its sale to anyone, or in any private secondary market, without the express written consent of the founder, the chief executive or the board of directors. Obviously this becomes a problem when an employee wants to sell his or her private stock. And who wouldn’t, if for instance, the stock is issued to employees at a $500 million valuation, and then sold to outside investors at a $1.5 billion valuation.

This is often the point where the founder steps in and says, sorry, no sale, or at least not at the higher valuation. Selling implies the person is no longer a true believer in the company or in its mission. This dynamic falls especially hard on early investors who are not company employees, those so-called “series A” or “series B” venture-capital investors who would like to sell at the higher valuation but can do so only with the founder’s or chief executive’s permission and only at the sanctioned valuation. Employees looking to diversify their wealth also often feel frustrated.

Whether the Securities and Exchange Commission has examined these odd discrepancies in valuations of private tech companies is not known. A spokesman for the S.E.C. declined to comment.

Regardless, the payoff, of course, is an initial public offering of the stock. Once that happens, as with Snap Inc. last week, 409A valuations are no longer needed. With the company shares trading, the market sets the valuation at nearly every second of every day. Independent valuation experts with their false precision are no longer needed. Before that big event, though, 409A valuations allow a lot of stock to be issued to insiders at prices that don’t make a whole lot of sense.


© 2017 The New York Times Company


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