Last year was a great one for startups. It was a record year for companies going public, valuations for pre-IPO companies were skyrocketing, and fundraising also shattered records.
But 2022 is going to be quite different. Many of the companies that went public last year have seen their stocks plummet, and those woes are seeping into the private market as late-stage tech companies are starting to see their valuations trend downward.
While nobody can predict the future, lowered valuations aren’t as much of a foreboding sign as they’re made out to be. Just as what comes up must go down, what’s down will most likely go back up. But while things are on the downswing, there is a unique opportunity for startups to reduce their valuation.
Yes, reduce. Trying to maintain an inflated valuation doesn’t necessarily do you any good. What’s more, it can actually harm your company’s future growth.
Reevaluating your 409A now is the right thing to do for your employees, because their equity isn’t up to date with the rest of the market.
Though it may seem counterintuitive, a lowered valuation could reap benefits for your employees and your company’s recruitment efforts. On the other hand, a high valuation increases the cost to exercise, or buy, those stock options.
A lower valuation will ease those costs and make equity packages more attractive to new hires, especially in a job market that is red hot with recruiters competing for talent.
What is a 409A valuation and why is it important?
Stock options are granted a specific price, known as the strike price. The strike price will be similar to the 409A at the time the option is granted, and that never changes. What does change is the company’s valuation, and that is reflected in the 409A valuation. That, in turn, impacts the fair market value (FMV).
When an employee goes to exercise, or buy, their options, they need to pay taxes on the difference between their strike price and the current FMV. That’s because the IRS counts the increased valuation of the stock as income, which could be subject to income tax or the alternative minimum tax (AMT).
Many employees take a “wait and see” approach to their equity. Once they believe their company has “made it,” like reaching unicorn status, they feel it’s less risky to go ahead and buy their stock options.
For new recruits, a lower 409A valuation will translate into a lower base cost of their equity. This makes job offers more attractive, as a dip in valuation doesn’t necessarily mean the company won’t have a healthy exit. For current employees, it means they can pay less to exercise their options and be better prepared for a potential exit.
For example, Instacart filed to go public after announcing a valuation cut with the explicit message that it would improve compensation packages for new hires.