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Valuation Shell Game:
Silicon Valley’s Dirty Secret
Street Scene
By WILLIAM D. COHAN
MARCH 8, 2017
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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.
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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
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(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
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