Hiring people and raising money are two of the most important challenges that start-ups face.  Neither task is a one-time undertaking, and in the current environment, even the most successful companies will spend years raising money from private investors and spending it to scale up their operations.  Making things more complicated, there are many rules that govern the equity compensation that start-ups use to lure desirable employees away from the stability and comfort of working for larger corporations.  One of the best known, and most inconvenient, of these restrictions is that companies can’t grant options while they are fundraising, or so many believe.

This turns out to be an oversimplification.  It is true that a fundraising is a “material event” that ends a company’s safe harbor for granting options.  Thus, the company will need a new determination of fair market value in order to be in compliance with Internal Revenue Code (IRC) Section 409A.  However, the company doesn’t need to wait for the financing to close to update its valuation.  In theory, a valuation can be completed at any time, reflecting what was known or knowable at that point in time.  For example, a 50% weighting could be put on a scenario in which the company raises money and a 50% weighting could be put on a scenario where a round isn’t raised in the short term.  In practice, though, it can be costly and time consuming to update a valuation every time the outlook for a company’s financing changes.  Still, management should have a good idea of the terms and size of a round well before it closes, for example once there is a signed term sheet, and getting started on a new valuation at that time can reduce any disruptions in granting options to new hires.

Sometimes the timing just doesn’t work out, though.  For example, if you are going back and forth with a couple investors on terms, and at the same time, want to bring in a key hire.  One option is to agree to grant the new employee a certain number of options, start the vesting on their hire date as usual, but not “grant” the options from a legal perspective until there is more clarity on the financing and a new valuation is set.  This is commonly called back-dated vesting, and companies are free under 409A to establish whatever vesting terms they like.  This approach may not completely solve the problem, though, since you won’t be able to tell the new hire what their exercise price will be before they agree to take the job.

For more discerning potential hires, there are several ways to compensate them for the likely higher exercise price of their options.  First, it’s worth pointing out that while the exercise price is higher, the company they are joining is also more valuable after the financing.  Second, you can offer to gross-up the number of options they received based on the increase in the exercise price.  For new hires familiar with option pricing theory, you can offer to grant the employees a set dollar value of options, with the number to be determined based on the new 409A.  To keep things simpler, the company could match the percentage increase in the exercise price with a percentage increase in options granted.  These strategies would raise the cost of hiring the new employee, but to bring in the right person in a timely manner, it can often be worth it.

Complying with 409A regulations can be costly, but they are sometimes made more burdensome by companies that don’t understand the specific restrictions.  It is certainly important to avoid granting options outside of a safe harbor period.  However, there are strategies that companies can employ to minimize the disruption created by a safe harbor ending.  By getting a new valuation completed early on a pro-forma basis and back-dating vesting, companies can continue to hire new employees even as they fundraise.

What can be done to minimize disruptions to hiring caused by equity financings:

  • Get a new valuation as soon as you have a good idea of the size and terms of the next round.
  • If you need to provide a new hire with options during a period of significant uncertainty about financing, you can back date the vesting to the hire date but grant and price the options once a new valuation is completed.
  • For potential hires who aren’t satisfied without knowing the exercise price, you can offer to gross up the number of options they receive based on the change in the exercise price.

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.

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