Starting Up & Right: Episode 04: 409A Deep Dive






Trae Nickelson: Hi, and welcome to another episode of Starting Up & Right. If you're a startup founder or a startup finance professional, you're in the right place. I'm your co-host, Trae Nickelson. To my right, on your screen, is your other co-host, Ryan Keating, startup CEO and managing partner of Keating Consulting Group here in Silicon Valley. Hey, Ryan.

Ryan Keating: Trae, hello.

Trae: Today, we are going to talk 409As, and we're going to dig pretty deep, and to help us do that, we've got a special guest on the show today. It's the CEO of valuation firm, Scalar, Zak Nugent. Ryan, before we bring Zak in, tee this up for us. Tell us a little bit about your initial thoughts on 409As and tell us what we want to cover today.

Ryan: Yes, this is a great topic. I'm looking forward to this. This comes up all the time with our clients. Bottom line is, if you want to, as almost every startup does, you want to incentivize your staff, your advisors with options, so ownership in the company, to be able to grant an option, you need a fair market value. Today, it is a newer thing, which Zak will give us background on. This has been around for 10, 15 years, maybe.

When we started, the notion of 409A didn't exist. Nowadays, to establish that fair market value, you go and you pay for a report and it's called the 409A, which is no doubt some tax code or IRS code, I'm sure. That, basically, gives you a value that you can use for a period of time. It does expire and it does need to be renewed, but it gives you that value that you set your option price at for your employees or for your advisors. Today, what we'll talk about is how long do they last, how are they established, when do you need them, and some really other interesting things that Zak has helped us with over the past decade-plus that we've been working together.

Trae: Great. Speaking of Zak in Scalar, tee that up for us too. Tell us about your relationship with Scalar and why they've become one of your go-to resources about 409A issues from a CFO's perspective.

Ryan: Yes, thank you, you bet. Zak, welcome.

Zak Nugent: Thank you, happy to be here.

Ryan: Yes, so excited to have you. We've literally been working together, Zak and his firm Scalar, have been helping us for well over 10 years. The product that we work with them most closely on is the 409A. 409A's, you can get them a number of ways. Keep in mind, our clients are very early stage. As a company grows and becomes more sophisticated, there are different requirements, different needs, different products that you'll need.

Our very early stage companies, they need a 409A, again, as I said, when they want to issue option grants. There's a couple of different ways to go about getting this. A lot of companies these days will work with a cap table management program, a very common one, it's called Carta, and with a certain level of a subscription, you'll get a 409A every year from that service.

I prefer to work with Scalar, specifically, but, in general, a firm where there's more interaction, there's more professionals, there's more conversation about the inputs and the goals, especially at this early stage, you just can't look at data. You just can't look at the store. You just can't look at metrics because a lot of these companies don't have metrics, enough that the number of observations is irrelevant. Working with a firm like Scalar, you really get the chance to discuss the business, discuss the company, and arrive at more of a valuation that makes sense and it's not just formula.

Trae: Nice. Zak, he set that up pretty nice for you, so welcome to the show. Why don't you start by introducing yourself and tell us a little bit about Scalar.

Zak: Love to and appreciate the opportunity to be here with everyone. Scalar, we have been in the valuation business since 2009, and really, the ethos of the firm go back to this very topic, 409A valuation. We started our business on the premise of helping early-stage startups value their stock options for the purposes of issuing deferred compensation. Today, Scalar is 50-plus person. We do approximately 200 valuation engagements a month for a number of venture-backed, private equity-backed companies throughout North America. That's just a high level over who we are.

Trae: Great. I know for 409As are your bread and butter and you guys have gotten really good at those, but that's not all you. Just to give a better understanding of the scope of your broader perspective and to illustrate your firm's mastery of nuance and complexity, tell us briefly about some of the other related services that Scalar offers.

Zak: Yes, I appreciate that, Trae. Scalar offers valuation services. Really, our core niche is institutionally-backed company, venture-backed, private equity-backed, and publicly traded companies, and then, also, working with their investors. With that, there's a suite of services that we offer, tax valuations tend to be one of those, 409A being probably the most prevalent, but we also get involved in helping founders and their executives with their estate planning as they move their shares into trusts. We also work on the financial reporting side.

As companies scale up and they go from that early-stage startup and they move into that growth stage, late-stage company, we start to see more like tuck-in acquisitions, you start using your own private company equity to make acquisitions. That all needs to be valued. It needs to be valued from both a financial reporting purposes, and then, also, we also help folks corroborate purchase price. We get involved in the transaction advisory side.

Oftentimes, we'll work with either the buy side or the sell side, but as people want a third party just to poke and prod at the valuation, just to say, "Hey, does this make sense?", so we get involved there as well, and then, the unfortunate circumstances of shareholder disputes. When there's a cramdown, when founders break up, when you're pushing somebody out, oftentimes, you have to end up valuing what the underlying security is worth, and we get involved in those as well.

Then, the final thing we do from the investor perspective is we get involved on the mark to market. We hope investors value their underlying holdings in portfolio companies that haven't had a recent securities transaction in a duration of time. There's a high-level overview, 30,000-foot view of a lot of the services, but it all ties back to what's the fundamental value of a security.

Trae: Perfect. We've set the stage, let's dig in. Part of my job here is to ask the dumb questions. Let's back way up, assume I know nothing, I'm a first-time founder trying to set up some stock options to recruit some key team members. Ryan, you go first then maybe kick it off Zak. How do you introduce 409As to founders?

Ryan: Sure. The very simplest explanation-- This is really where our clients tend to gravitate anyway. Most of our clients, one of the first times they've been funded, first time they've had the creation of an option pool, first time they're going out and actually offering stock options as a part of compensation, so very first thing, first time they hear the term 409As when the topic of options pools coming up, and I'll tell them, "Look, you have to set a price for what you're going to set as the market value for your option, for your stock. You want to have this report, tell you what that should be. It's a third party. It allows the board to establish the price."

For the first time, they're hearing this term 409A, and my explanation to them is you've got to have it to safely and accurately price your option. Then, that's basically as deep as I go, and then, I'll bring in an expert like Scalar and have them really take the company through the process.

Zak: Yes, that makes sense. Really, the ethos of a 409A, it's a tax code. It's IRC 409A valuation. It's IRC 409A. You need to get a valuation when you are issuing deferred compensation. Oftentimes, it's options. I mean, that's mostly what most startup companies use.

Trae: So mainly for tax purposes and pricing common stock options, it sounds like pretty important step that I need to get right.

Zak: I would say, it's extremely important. I think, ultimately, at the end of the day, it's for dual purposes really when it comes down to it. The first purpose that we often talk about is for tax purposes, ultimately, determining the value of the underlying security for issuing stock options from a tax perspective. There's also the financial reporting perspective that as an early-stage entrepreneur CEO, you don't necessarily think about, but as you scale up your business and you grow, making sure that you have a 409A valuation is incredibly important for your financial statements.

It's really a dual purpose. It's for 409A purposes as well as what's referred to as accounting standards codification 718, which is probably a little technical, but why it matters is, if you scale up your business and you go through an IPO, one of the main things you don't want to have is a cheap stock hit. Ultimately, it does matter for dual purposes.

I guess there's a third purpose in there that just, ultimately, from a financing and an M&A transaction perspective, oftentimes, from a rep and warranty perspective, they'll ask, "Are you 409A compliant?", because the investor coming in on the deal or the acquirer doesn't want to have to deal with any potential tax ramifications, or they don't want to have to deal with it from a financial reporting perspective. It's probably that. It correlates with the other two, but that's really the purpose of the 409A valuation. It's a compliance-driven service/product.

Ryan: Even to add to that, just where we work with clients on, where they really see it enabled is, the board will not approve option grants without this in place. They understand the liability for all the reasons you just listed, Zak, around tax, exits, and audit, so they will not approve grants. The board themselves, just to make sure that the hygiene is covered, will say, "Option grants won't be approved even if the 409A is expired," if they'll insist on one for you to be able to use your option grants as part of your compensation to your employees.

Zak: Yes, correct. From a fiduciary perspective, from a board, you're relying on a third party expert, and it's a check the box for that and nobody wants to assume risk by pricing their own options.

Trae: Okay. A 409A isn't just a one-time thing, right? Zak, how often do I need to update my 409A, get a revised 409A?

Zak: For an early-stage company, it's advised to get a valuation done annually, or if there's a material change to the company. Typically, we refer to a material change deemed as a qualified financing of some shape or form. That's typically what it's referred to. In the world of COVID, it could be deemed as a pandemic or something that would be a caveat that would, in fact, make a material change to the company. That's oftentimes when you need it. Every 12 months or when there's a material change to the company, that's when you need and how often you should get a 409A valuation.

Ryan: Interesting, and you saw with COVID, that being a material event. I know a number of our clients had material changes in their underlying business and funding and value and got new 409As. Are you still seeing that, 10 months in?

Zak: We’re seeing it less so. If we think about the spring and the summer, we definitely saw an impact of COVID and how it affected businesses. I mean, a lot of people revised forecast down, they burned more cash, they had to go back to potentially raise more financing. You definitely saw headwinds associated with COVID and they needed to be factored into the valuation, and maybe that recent securities transaction no longer was considered a relevant indication of value.

We also saw tailwinds associated with it. For example, we have some clients that are in the telemedicine space, they saw a boom in their business. . It really just depends on the business, the industry, the vertical in which they're tackling, but COVID definitely had an impact. It just depends on how it impacted your business.

Trae: I know these things can get complicated. Zak, I know your team at Scalar does some deep dive, qualitative, analyzing, aggregating, algorithming, to triangulate a justifiable 409A price. It’s a healthy mix of art and science. Tell us at a very high level about your process and how you balance the art and the science.

Zak: The process is-- I mean, candidly, there's industry standards. The way I view 409A valuation is, there's a guide we, in the industry, adhere to. The guide basically creates a sandbox, and we need to stay within the sandbox. Within the sandbox, we can dig tunnels, we can hang out in one corner or the other corner, and we can get creative. It's not a total one size fits all.

There is a level of creativity that can go into this or malleability based on what's going on with a company, so understand the fundamentals of the business is critically important when you're doing a 409A valuation because it's not just, "Hey, I have a post-money valuation, why don't we just run it through those calculations you still alluded to and give me a price per share of common?", because there are going to be variables that go into those inputs, and not to get into the granular details of the math, but those equations require inputs that we need to get from founders, and then, we need to have a dialogue about those, and then, on top of that, we need to make sure we can corroborate them with other data.

It is still a data-driven exercise, but it is such that you want to be able to get the collaboration of the founder or the finance team or whomever is running point on it because they know their business better than we do. We understand valuation, we understand industry verticals and how to value those industries, but the actual specifics of each underlying business, really, that needs to come from the founders because they're going to know what's going on [inaudible 00:15:05] basis.

Trae: Yes. Obviously, things can get pretty complicated, pretty complex, which usually comes with a little bit higher price tag, takes a little more time. What if my needs are pretty simple? I'm pretty early stage. How do I know when I need a Scalar versus a simple cookie-cutter 409A? Zak, how would you guide me here?

Zak: I think it really depends on your stage size, what your turnaround time needs are. Sometimes, people wait until the last minute they need to issue equity grants. Really, valuation, the way I look at it is, there are some services that are very much like a size nine shoe, and in those circumstances, if you're size nine, it's probably a great fit for you. It's going to accomplish your objective, but if you're 13 and a half, trying to fit a 13 and a half into a size 9 creates a lot of complications.

My recommendation is talk to a couple of providers, get some insight from each one of them, find some that you feel comfortable with that you feel understands your business and the approach they're going to take is going to be reasonable for your company stage and size, and then, move forward with them. I've been in the industry a long time, and I can tell you there's some really good firms out there besides Scalar.

Trae: No, they're not as good.

Zak: I think Scalar is obviously the best notwithstanding-- I mean, with all due respect to our industry, there's some really good players out there. I think you should talk to people that you feel comfortable with.

Trae: Yes. Sometimes, a cookie-cutter works just fine, but how do I know when I need something a little more custom or when I am a size 13? What's your approach to customizing for each scenario and ensuring that the shoe fits?

Zak: There's very much an art to this. As I alluded to earlier, you want to make sure that you have the ability to hear out the client, you understand what's going on with the business, to be able to make those decisions that are necessary in your valuation, and then, be able to support those because this isn't-- In some way, it's an insurance policy. Why do you get a 409A valuation? You get a 409A valuation in those scenarios that you're successful because, inevitably, you're going to get people to start questioning what those equity grants were priced at. If you don't have something that can corroborate that price, you're going to be in a world of hurt.

Even when you get that report, they're going to still poke and prod at it. You got to make sure the report was done right. You got to make sure the underlying fundamental analysis was done right. That's where using a firm like Scalar really comes in. We take that holistic approach, that collaborative approach, and we make sure our deliverable is such that it will hold up if it were to be questioned or something were to come up that would be adverse to the equity grant that was already issued. That's typically what I recommend when people are thinking about selecting providers.

Trae: Perfect.

Ryan: That's one of the main reasons I really try to advise our clients to work with Scalar is, one, not many of our clients have a size nine shoe. There's so many different scenarios and needs and stages that the incremental cost, which we're not talking about much in the grand scheme of things, to be able to actually work with a firm that gets to know your business and understands the actual drivers and the stage you're at and the inputs other than what you feed into the algorithm. To me, that's definitely money well spent.

At the end of the day, when it comes down to it, this is what I tell the boards that we work with. It is an insurance policy. You need to have this in place. If it ever gets questioned, you just hand them the report and say, "Here it is." For the most part, they'll go to Scalar whenever and say, "How did you come up with this?" It's really that. It's an insurance policy.

Zak: Yes.

Trae: Yes, cool. All right.

Zak: Sorry, Trae. To that point, that's the nice thing about engaging a firm like Scalar. This is my Scalar plug here. Ultimately, somebody's been around in business and been doing this long enough to where that question does come up three years from now, you know the firm's going to be there. They're going to be reliable and they can respond to those questions. Realistically, it's as easy as handing it over. Those questions should be responded by the valuation firm. That's our job. Our job is to defend the analysis that we put forward.

Ryan: Nice.

Trae: Let me throw this one at you guys. As a founder, I've established a tenacious habit for arguing and justifying the highest valuations I can possibly get. With a foreign 409A, am I supposed to be rooting for a high or a low share price?

Zak: Do you want to get diluted or not get diluted? [laughs]

Trae: Explain that to me. Yes, explain that to me.

Zak: It's funny in that we all want-- Typically, on a 409A valuation, we're arguing for a low valuation. Valuation is a range. We need to think about that. In the context of tax valuations financial reporting, we are determining a price based on a theoretical market. That theoretical market typically has a range. Until someone's willing to write a check for the security, that would be, by definition, market. We create this range, and we typically anchor to the low end of the range for the purposes of 409A valuation, but we have to understand, every time you issue equity at a low price, it's more diluted to the full, overall cap table.

Do you want a high valuation? Do you want a low valuation? Most times, you want a lower valuation. Ultimately, the reason why you're arguing that is because, let's assume for argument's sake, I have $1. I have $1 and it's made up of 100 pennies, and I can take that 100 pennies, and I can give 5 of my pennies to five different people, so I'm left with 95 pennies, and they all have 5 pennies. That 95¢ now is worth $1.10 by giving those other 5 pennies out, I'm going to do that every day of the week. Even though my percentage of the pie is worth less-- Excuse me, my percent of the pie is less, my value or my 95¢ or my 95% is worth now 110¢ or, excuse me, $1.10.

It makes more sense for me because-- That's why bringing on teams, and as you're trying to recruit people, you want to recruit the very best people you possibly can. You're willing to get an aggressive strike price because you want to build that team around you because by having that right team around you, then, ultimately, the value of the overall pie gets much larger. It's a really long-winded way of explaining it. I would say that the best way of thinking about it is, on a 409A valuation, you want to anchor to a low reasonable value that can be incentivizing those key members of your team that you're going to be recruiting to help you build and scale the business.

Ryan: I like that explanation. It tackles both sides. Really, the argument we usually hear is low, we want the lowest price possible because people think of it is, again, that incentive they're offering to build that team. They're granting options, and they want that strike price to be as low as possible for that recipient so it's less of a financial burden for them to exercise those options, ultimately. It's short-sighted. Well, it's looking at one part of the equation. It's relevant, but I do like the way you think about the fact that it's more diluted. You're selling equity at a lower price.

Zak: I mean, not to digress too much, but venture thinks about these different than private equity. Venture is much more amenable to anchoring to that low end of the price per share. I always say that's like the ethos of Silicon Valley, that's the ethos of building around a team, that's the ethos of everybody's on-board driving for the same results.

Private equity, honestly, the argument sometimes is we have with those types of companies is like, "Hey, no, the value needs to be different than the preferred price." Preferred price may be, participating preferred within a 12% accruing dividend, which would ultimately be worth significantly more than common shares. For the most part, I would say, for those early stage, first round of financing, first safe note, first convertible note, as I'm scaling up my business, you want to get that value in a reasonable number that you can incentivize people.


Trae: As a founder with my start-up CFO, we're out there pitching and fundraising, we want as high valuations we can get, but when we're doing 409A pricing, basically, we want as lower prices we can justify. As the CEO, can I consider the two valuations just completely decoupled?

Zak: Yes. There is the value of the business. Sometimes, there's a bit of confusion. You have to value the enterprise or the company as a whole to determine the value of security. Maybe let's talk about it maybe the two points we brought up. The first is, are we decoupling the 409A valuation from my ability to go raise a future round of financing at a much higher valuation? The short answer is, maybe. I'll explain.

When we think about it is, again, going back to this range of values. The best analogy I look at it is if I'm going to go stick my house up sale-- I'm going to put a for sale up in front of my house, and I'm going to solicit offers. I'm going to get offers that are going to be above the asking price and I may get offers below the asking price. Ultimately, I'm going to decide on which offer is the best for me, personally, when I sell my home. Maybe it's an all-cash offer that can close quickly that's a lower offer, and maybe the higher offer is contingent on me selling my home and I have to get a loan. I may not take that. I may take the cleaner deal.

The market is really going to set the price when they're willing to write a check. The valuation for the purposes of, theoretically, for 409A and when you're raising money, there is a range of reasonableness. When we go to raise money, there's an argument to be said, "What do you want to do?" You're going to anchor to the higher end of the range. You're going to go out to market and say, "I feel like we need to go out and raise at this number." You’re going to go have conversations with investors, and ultimately, the market is going to price that deal based on whatever the term sheet you received and you exchange equity for a check.

In the world of 409A, we create a theoretical market because we're actually not writing a check. We're saying what is the market's saying based on data, and the data being market company comparables based on precedent transactions, publically traded company comparables, as well as like market discount rates for discounted cash flow. Oftentimes, for a 409A purpose, we're anchoring in the low end of the range. It's still within the range of values, it's just on the lower end. 

Then, with a 409A that's different than when we think about raising capitals, on the 409A perspective, you're going to apply discounts because we're valuing an individual security, and an individual security may sit behind a liquidation stack, and then, it may also sit behind this discount for lack of marketability. When you look at that football field analysis, if you will, that range, you may be trying to argue a range of values, or for a pre-money here, and the value of your common maybe way over here, and that's okay. That's doable and it's defensible.

They are decoupled in some way, but realistically, thinking about the overall value of the business, it's still there. You don't want to be too decoupled. You don't want to go out and say, "Hey the value of my common is par, and I am just going to go sell my equity at a $100 million valuation." That's where it gets to be problematic.

Trae: Got you. The 409A and the company valuation, they are not the same thing, but they can't be completely decoupled, but they do have significant stretch between them. When there is a market base, someone wrote me a check valuation to my company, it makes sense that does have at least some effect on 409A formula. What about if I am earlier? What about if there are no preferred shares, no market-driven valuation has occurred, and I am still using non-price convertible notes or safes, do I need still need a 409A? If so, how do the formulas change to that?

Zak: In those cases, it's going to be a slightly different approach because depending on how the financial instrument structure. If it's a convertible note that has a nominal interest rate that's accruing and payable upon maturity and it doesn’t have a valuation cap, then we would model it like debt, candidly. You basically have a breakpoint that needs to get paid prior to any other equity holder receiving any liquidation proceeds.

In that context, you could argue it is a pre-revenue company. In those cases, it can be a very challenging exercise because, ultimately, what's the value of the business if you have this convertible note instrument, and here's the thing, the caveat, without a valuation cap? We have to get relatively creative and subjective to come up with a number that makes sense. If somebody's willing to write you a check for $3 million on a convertible note, there is some inherent value. It's not worth zero. You have to come up with some ascribed value.

At a minimum, most businesses are worth, in this case, at least, invested capital or cost, which is $3 million, for example. That's one scenario, the scenario where you have a valuation cap and negotiate it in a convertible note. I'll use convertible note, and then, we're going to save. In a convertible note, that becomes an actual point of negotiation. From a valuation firm, we can't ignore the fact that you negotiated a valuation cap in the convertible note. That is actually a scenario we could potentially model, where as if that financial instrument converts at the cap with the appropriate discounts.

Then, you can run another model which again is that invested capital scenario and you could weight them and you probability weight based on what the potential outcomes are. In that scenario, the value of common will be higher with the valuation cap than without the valuation cap. Safe notes work really comparable to that. They just don't often have an accruing interest rate. They're going to convert at a discount or they're going to convert with that valuation cap or both. It is a probability-weighted scenario.

Trae: Okay. Zak, as a founder, I can probably get real creative, come up with a lot of ways to make your job more complicated. What are some things I should keep in mind and some mistakes I should avoid to keep it simple for you and to make sure that everyone's as comfortable as possible with the results? Is that a fair question?

Zak: It's a fair question. I think in the early stages when you're raising capital, don't get too creative. There's some pretty standard term sheets. There's standard documents that are out there. There's so many good attorneys out there. I would just try to go with something that's pretty plain vanilla. If your investors start requesting things that are outside of what would be plain vanilla, I would probably be wary of taking their money. It complicates things from a 409A valuation perspective, but more than anything, it just complicates your business going forward if you get things that are outside of market.

Outside a market would be onerous terms related to the money that you're taking on that would ultimately prevent you from raising future rounds of financing and scaling your business. That's my recommendation. Just make sure you select corporate counsel. There's a lot of really good corporate counsel in the valley, so select somebody that you feel comfortable with, that's going to use kind of a plain vanilla term sheet. Whether it's a convertible note, a safe note, or priced round, that makes it relatively straightforward and easy.

Then, the other thing too, as you scale up your business, is hiring somebody to help you with your financials. One of the things you want to make sure-- I think, Ryan, you can attest this. I think it's where, Ryan, you'd be a good fit in these early-stage companies is coming back in and making sure you have buttoned up financials so we're not looking at an income statement at a QuickBooks that hasn't been really reconciled correctly. Those are probably the recommendations that I'd have for anybody as they're trying to get ready for a 409A valuation.

Ryan: I like that question, Trae. Just something that I see and I'm curious, even before the term sheet, we're talking founders setting up their initial cap table, this will come up a lot, where they want to create like this superclass of common, the FF class, where they get 10X voting rights and no dilution and they control the biz, Zuckerberg class, what's some advice for founders there because I love the advice of don't complicate things? I always tell our clients, "Don't sell your cap table. Sell your technology. Don't explain all the creative stuff you've tried to come up with. Just keep it simple and raise money based on your idea." What do you see in that area, what the founders tried to do that maybe you would advise, even from step one, to avoid?

Zak: We don't see the same-- I used to see the FF shares much more frequently several years ago. I don't see them as frequently as I used to. They still exist. I mean, people still add them to their cap table. My perspective is if you're able to get those terms and investors are willing to write a check, it doesn't overly complicate it, but it just needs to be accounted for. Keeping it simple just makes it easy for a couple of reasons. One is, whatever terms you raise money at, typically, in your first round of financing, whether it's-- Convertible, it's a little bit different. It's safe and it's a little bit different, but that first price round of financing, whatever you raise the terms at, typically, are mirrored in subsequent rounds of financing.

That's why my advice for most entrepreneurs is take a 1X nonparticipating preferred instruments because it provides you the ability to differentiate preferred and common to give you an aggressive strike price. On the upside scenario, as the company scales and grows, those preferred investors are going to convert their shares from preferred stock to common, and then, you're all basically participating on a pro-rata basis, which is what you ideally want to do.

That liquidation preference becomes less relevant, in fact, it becomes irrelevant because they're converting to common shares. If you get a more creative security or more owner security, like a participating preferred share, then in that context, the investor gets their money back first and they participate. That also means, subsequent investors, they're going to look back at the cap table and say, "Well, investor A got it. I'm investor B, I want the same terms."

Very quickly, your liquidation stack gets to be relatively onerous for your founder and the value of your common shares diminishes over time, and an absence of going through an IPO, which while there are a lot more IPOs today, the probability of a company with an IPO is still less than an M&A transaction, you're going to end up having to-- Your percentage of your ownership gets diluted such that you will end up with less of the pie if you have just raised a 1X non-participating.

In summary, the way I view it is, if you get a valuation on a pre-money valuation from an investor, the valuation's slightly less but the terms are 1X non-participating versus slightly more and it's participating preferred, take the non-participating preferred because in the end run, you'll [inaudible 00:34:48] more.

Ryan: That's a really good lesson because working with so many startups and VCs, we'll see where VCs will give on the pre-money sometimes because that's how founders and entrepreneurs like to measure how they did, what was you pre-money, and they'll say fine, but then, they'll stack on some preferences or some economic right, then it becomes more onerous, but they got that pre-money. It's not the target to focus on, sometimes, when you look at the big picture like you're saying.

Zak: Yes. From an investor perspective, if I could purchase participating preferred, I would much rather purchase that type of security, but it is onerous. I mean, it just really is once it's all said and done. Those are all things to consider when you're thinking about valuation.

Ryan: Right.

Trae: Perfect. Once again, the KISS principle usually applies for the most part. Last question, and this subject might apply more to somewhat later stage companies but it's often on a founder's mind even in earlier stages, and that is the secondary sales and realizing some early liquidity from my own perhaps founding or common shares. Zak, how does secondaries affect subsequent 409As?

Zak: There's really three different scenarios for secondaries and the impact to 409A vary based on how you structure it. The cleanest way to structure a secondary-- When I refer to secondary, this is essentially when you raise money or you sell equity in exchange for cash and the proceeds of that cash don't go to your balance sheet. A primary transaction is you're selling equity in the form of a preferred random financing, sometimes common, but that the proceeds of those securities are going to the balance sheet of the company to help scale and grow the business.

In a secondary transaction, you're getting liquidity. You're selling your stock to somebody else, you're going to take home cash, and they're going to take away with your shares. How does a secondary transaction on common stock affect a 409A valuation when you're issuing common shares for different compensation? It really depends on three different scenarios. The first scenario is in conjunction with a preferred random financing.

As a company scales, goes from a series C to a series A, to a series B, et cetera, oftentimes, the founders are able to get some level of liquidity in conjunction with the primary random financing. The cleanest way to do it that has basically zero impact on the 409A or almost no impact on 409A is if the preferred investors purchased preferred stock and the proceeds from that preferred stock sale go to the balance sheet and the company then takes those dollars and redeems your common at a price.

It's a case where the preferred shareholder, they end up with preferred shares, but you, the company, you the founders, you ended up selling your common. You sold the common to the company. Ultimately, at the end of the day, it's a pretty clean transaction, it would have zero impact on the company. That's the cleanest way of doing it. Raising, basically, a preferred random financing, part of the proceeds of that on the balance sheet go to redeem common.

Second way is you sell your common shares in conjunction with a preferred random financing. Now, this is where it may or may not have an impact on the value of your common shares, and it really depends on the circumstances. In the AICPA valuation guide for value and privately held stock, it outlines a metrics here. One of the things to take into consideration is who is that secondary available to? Is it available to just founders, limited number of people? Is it non-repeatable? Is it just related to this transaction? Is it a small percentage of the cap table? If the answer to all those questions is, yes, then it would have no impact on the 409A valuation.

If there are answers to yes to some of those questions, then it varies and it takes some level of deeper questioning to ultimately consider whether or not we weight it or not weight it. That's second scenario. More often than not, we don't weight it though. The third scenario, it tends to be the more onerous scenario from a secondary perspective that may and more than likely does have an impact on the value of common. That's when you just sell your common shares outright, not in conjunction with a preferred random and you just sell them to a third party.

This is typically with growth stage company where, if I'm a growth stage company, I leave the company or I'm still at the company and I said, "My wife is bugging me. My partner's bugging me, and we want to buy a new home. I want to take a couple of million dollars of liquidity. My equity on paper is worth $50 million, and I want to sell $2 million dollars of shares." You can go ahead and do that. There is a market for that. You go out, you run a process, and somebody ends up buying those $2 million of shares.

How does that impact 409A? Again, we go through that same metrics that we talked about in step two, but ultimately, what may end up happening is we may end up putting some weighting on it. The weighting may be minuscule, maybe 5% or maybe 10% depending on how big the transaction gets, but there would be a weighting towards it, which would inevitably increase the value of common. Meaning, that the value of common will be impacted based on direct [unintelligible 00:40:19], not in conjunction with random finances.

Those are the three scenarios as it relates to a secondary transaction. You really need to be mindful of those as you're going through a secondary process, and I would literally get on the phone with your valuation firm and ask them what's the impact before you move forward with the transaction because you want to minimize the impact to your 409A so you can continue to incentivize your employees.

Ryan: We see that scenario come up with our clients. Basically, what you described where there might be a round coming together that's maybe a later stage, like B round, and for the first time, the founder can sell some of their equity into that round. The interesting thing and just for my clarification, in that third scenario where the founder is selling shares unrelated to a transaction, finding a third party, going to one of these marketplaces where you can transact, does anybody just say, "Well, let's look at the most recent 409A. That's where the commons was"?

Zak: You would request that, for sure. Some people trade at the 409A price. Most people are trying to negotiate a much higher price than 409A valuation. Oftentimes, in a secondary market, the question isn't necessarily what's the 409A, other than that, maybe an item of due diligence. The question is, what's the price of the most recent preferred [inaudible 00:41:40]? Realistically, they may be discounting it in that scenario only by maybe 20% or 10%, wherein the purposes of 409A, you're just getting it much, much more.

The reason why you can argue for the larger discount is because, again, nobody's coming in and willing to buy the entire company at that price. They're willing to buy small, little positions with the understanding or the hope that the company continues to increase in value over time. Oftentimes, these smaller secondary positions that are happening, they may get [unintelligible 00:42:18] from the board and the current investors are buying them, or the current investors are passing on them.

It's one of those things where it's all circumstantial, meaning, we've got to look at it in case by case basis. There are multiple scenarios where it doesn't impact the 409A. There are some scenarios where it does. It's one of those things, again, oftentimes, we just have an upfront conversation with our clients just to see what the potential impact can or will be.

Trae: All right. Great. Let's wrap it up. Zak, thanks for joining. Ryan, thanks as always. There's a lot to chew there. We got some good, deep quality content in there. Cookie-cutters 409As, they work in some instances, but when it gets more complex, need a little more nuance and thought put into that, it's good to know that firms like Scalar are out there with a good hands-on approach.

Zak: I appreciate it. Thanks for having me, guys. I really appreciate it.

Ryan: Thanks, Zak, appreciate it. It's really, really insightful as usual. Thank you. We appreciate all the work we do together with you guys as well.

Zak: Thanks so much, Ryan really appreciate it.