ShmoopTube

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

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

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

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

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

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

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

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

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for scrap. you need to grant stock options to

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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employees a super low strike price number

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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stock and because glow bunny and conveniently over stocked this corridor

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

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

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glows. [glowing bunny poops]

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