Does Crowdfunding Affect IRC §409A Valuation?

Crowdfunding has become an extremely popular way for young companies to raise capital.  While not all of this crowdfunding is used to capitalize startup companies – there are lots of efforts to produce television shows or albums, to fund nonprofit or civic groups, to launch political campaigns, or even to back bizarre personal projects – enough of the money has gone to companies that crowdfunding is becoming a large source of financing, behind only venture capital firms and angel investors.

Inevitably, Teknos has encountered client companies which have raised crowdfunding and we have been asked:  Does crowdfunding have implications for the valuation of an early stage company, specifically for granting stock options in compliance with IRC §409A.  The answer is … it depends.

Not All Crowdfunding is Created Equal

The term “crowdfunding” is used loosely to refer to two different sorts of financing.

There are the types of campaigns launched on platforms such as Kickstarter, Fundly, or IndieGoGo.  Technically, funds provided through these platforms are donations (it should be noted that only entities with IRC §501(c)(3) status can provide a tax deduction to donors), even though many of the campaigns offer to provide rewards such as a copy of the book or album, to invite funders to a premiere, or, in the most notable examples, to ship a product when it is developed.

And there are the types of campaigns launched on platforms such as AngelList, Funders Club, Lending Club, and CircleUp.  The funds provided through these platforms can be structured as debt or equity investments.  Currently, most platforms allow participation only by “accredited investors” to avoid violating US securities laws.  However, the 2012 Jumpstart Our Business Startups Act (JOBS Act) directed the SEC to develop regulations to allow an exemption from the public offering registration requirements for Internet “funding portals,” subject to limits (the SEC rulemaking is not yet complete).

While obtaining funding from the first type of funding platform can help validate that a planned product has market traction and this validation may someday help raise equity funding, it has no directly measurable effect on the value of a company today.  In the terminology of valuation and accounting, this type of funding is not a “prior sale” (of the company’s equity securities) and cannot be used to estimate the value of the company and its common stock.

On the other hand, funding from the second type of funding platform often comes in the form of an equity financing (or a debt financing with an equity option).  So, using industry terminology, this is a “prior sale.”  And, if the data seems “relevant” (another valuation and accounting term), it may be possible to use to estimate the value of the company and its common stock.

Are Crowdfunding Transactions Relevant to Valuation?

So, what would make the price information “relevant” to a valuation?  We rely on the AICPA Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, for help in answering this sort of question.  According to the AICPA Guide, “the relevance of … market transactions to estimating the fair value of … equity securities … will depend on the facts and circumstances” (para.8.02).  And one of those facts is whether the transaction is “orderly.”

The FASB defines an “orderly transaction” as one “that assumes exposure to the market for a period…for marketing activities that are usual and customary.”  The AICPA Guide goes on to say that “in private company financing transactions, the usual and customary marketing activities generally include time for the investors to perform due diligence and to discuss the company’s plans with management or the board of directors, or both” (para.8.08).

In a different, but related, context, the AICPA Guide mentions a couple of other factors:  the availability of information about the company; and the sophistication of the investors (para. 8.12.b and 8.12.c).  We also consider the ability of the investors to negotiate terms, including price, with the company.  While many of the crowdfunding platforms do not put individual investors in a position to negotiate, at least two of them – FundersClub and AngelList – have structured themselves differently (by obtaining “no action” letters from the SEC and pooling investor funds to set up small crowdfunded “venture capital funds”) and they may have more bargaining power.  Leaving aside these two exceptions, commentators seem to think that crowdfunding platforms do not do much to facilitate an adequate due diligence review or meaningful negotiation of terms.

So, it comes down to the question of whether the new platforms for equity crowdfunding provide investors with an adequate opportunity to perform a due diligence review and to discuss plans with the company, whether there is enough information about the company provided to investors, whether the investors are sophisticated, and whether the investors are in a position to negotiate.

As we noted earlier, these factors will have to be evaluated on a case-by-case basis for each company.  So, the answer really is … it depends.

Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.

Special Note:  From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services.  However, nothing in this communication may be taken to represent the official position or policy of the IRS.  The opinions expressed herein are those only of Teknos Associates.

IRS Circular 230 Disclaimer:  Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.

Contact Us To Schedule A Free Consultation