Primer on 409A

The 409A Primer was first released in 2009. It was modified in 2010 in order to better address questions that readers frequently asked.  Originally, the document was prepared for Boards of Axiom Valuation Solution clients so they might better understand the process for and implications of establishing the fair value of common of privately-held companies. The number of downloads from our web site indicates the Primer has both been well received and achieved its intended purpose: to inform and educate Boards and management of privately-held businesses. While Board members and managements see the Primer as creating more transparency to the common stock valuation process, every once in a while we here the following frustrated refrain from a frustrated Board member.

 

“I do not get it! Why is the d– fair value of common so large relative to the issue price of the latest round of preferred stock? We are an early stage firm with so little revenue, how is it possible for the common price to be more than 10% of the latest preferred issue price?”

 

Boards naturally want to establish low common price since this sets the strike price for employee stock options. The  lower the strike, the less costly to exercise employee stock options, the better the alignment between investor interests and those of management and other optionees.  Low fair values for common are not inevitable for two reasons. The first is the central attraction for investors in a private firm: the perceived expected growth opportunity leading to a future lucrative liquidity event. Some of that expected growth will necessarily show up in the value of common. This is inevitable and the IRS expects to see evidence of this in every private common stock valuation. The second factor giving rise to common stock fair values higher than Boards often expect is that preferences of preferred stock are often not large enough.

The fair value of common will be minimized by:

  •  The higher the preferred dividend rate;
  •  The greater the liquidation preference (2x is better than 1x);
  •  The less the limit on preferred participation; and
  •  The lower the value per share at which conversion to common takes place.

The Primer has many examples of how the fair value of common is impacted by liquidation preference characteristics of  a firm’s capital structure.  The Primer is available on Amazon in Kindle format.

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