Economic Value Of Equity - EVE

finance a la shmoop. what is a 409a valuation. it has nothing to do with that

cleanser thing. yeah get that out of here all right. [cleaner scrubbed across a counter top]

well after a lab accident you were inspired to start a new company which

produces glow-in-the-dark bunnies .great Christmas gifts until you get bored with

them yeah. then you think well really cool glow-in-the-dark Stew.

you're the founder of globe bunny and you raised two million dollars in

preferred stock from investors. like most startups your shares are common stock so

if the company fails the investors get paid before you do. like if you sell it

for scrap. you need to grant stock options to

employees you're gonna hire. like you know your chief carrot officer or

executive vice president of adorableness. well you need to grant stock options to

those key officers but how do you price them like how do you set the value or

the strike price of those options ? well you own 4 million shares of common stock

and investors own 2 million shares of preferred priced at $1 each. that

preferreds a buck a share .so notionally your stake in the company is worth 4 [equation]

million dollars. but glow bunny barely has even a product. well ok it's a cute

product it's just kind of creepy. but it has no revenues and certainly no profits

so glow bunny is still at a highly vulnerable stage where it's very likely

to go bankrupt. statistically some 98% of these kinds of

startups either go fully bankrupt or pay back less than what investors you know

invested. so the 4 million shares common stock are certainly worth less than the

4 million bucks at this moment right? and it is the common stock which is the type

of stock which employees will get stock options in. that is an employee starting

at the company might get a modest salary and then a hundred thousand stock [equation]

options which convert into shares of common stock at a price. so the question

is what price are what strike price applied to those stock options is used

to set the price at which an employee can buy out those shares of stock? and

this pricing is a big deal because if the CEO just wants to gift to the

employees a super low strike price number

the IRS will view that as a taxable event and then bad things happen to

pretty much everyone. like it's a gift tax in that's taxable right ?well it's

the 409a valuation which determines that strike price and like Goldilocks

porridge you want it just. right if it's too high the employees don't get value

for taking the risk of working for the volatile startup you've started at a low

salary .and if the stock options are too low or priced too low well the IRS comes

a-callin .yeah Goldilocks. alright so the process a 409a valuation is made by

calling a lawyer or a bank who produces these valuation reports regularly .you [man on the phone]

know for a modest fee and yes glow bunny will pay them a modest fee .and in return

the firm will produce a piece of paper stating their rationale as to why via

say 4 million shares of common are really worth just a dime each not a

dollar. but they'll always be in a discount to the price per share of the

preferred stock because preferred always gets paid out ahead of common stock in a

liquidation. and there are multiple analyses the firm will look at. like 1

the price preferred shares were bought out like that dollar. 2 discounted cash

flow analysis of the projected revenues and profits and all that stuff over the

next n years. and or 3 comparable values for companies that are in similar or

ancillary spaces in like what their 409 a's were priced at at the same time. got [analyses of stock pictured]

it so a whole bunch of things go into the soup here or stew. and it's re

different not bunnies stew. now looking at you .alright and if they come up with a

diamond share well then it will be that diamond share that will be the strike

price of the options granted. meaning on the 4 million remaining shares they're

saying they're worth and give or taken four hundred grand. so if an employee who

just received one hundred thousand stock options in glow bunny with a diamond

strike price wanting to buy out their stock options and actually be a full

owner of the common stock as opposed to have options on it well they would need [equation]

to write a check for a hundred thousand times a dime or ten grand to glow bunny.

they would be the proud owner then of those hundred thousand shares of common

stock and because glow bunny and conveniently over stocked this corridor

well your very own truckload of bunnies. yeah there you go have fun cleaning that

up, and believe us when we say that everything about these bunnies

glows. [glowing bunny poops]