The Effect of Convertible Notes on IRC 409A Valuations

During the past few years, many young companies have used convertible notes instead of preferred stock to raise money from angel investors and even venture funds.  Because these same companies then go on to issue stock options to employees, we often are asked:  “What is the effect of a convertible note on IRC 409A valuation?”

A convertible note is a loan that will automatically convert into equity upon the closing of a preferred stock financing.  Sometimes these convertible notes have a valuation cap (e.g. “will convert at the lower of $5 million or the value of the Series A round”) and/or a discount (e.g. “will convert at 80% of the price per share of the Series A”).  Rarely does the amount raised using a convertible note exceed more than a few million dollars; most raise $1 million or less.

Convertible notes are popular with some entrepreneurs because they are easy and inexpensive to create.  And they are popular with some investors because they put off the difficult question of valuing an early stage startup company (on the theory that the value will be determined later, when the Series A is raised).

But convertible notes can have a downside too.  If the notes are not structured properly, they can make it difficult for a startup to raise the next round of funding and they can lead to a distorted value for common stock and stock options.

In a recent Wall Street Journal article, investors cautioned that convertible notes might lead a company to raise too much seed capital or to create an unworkable capitalization table.  Raising too much seed funding can make it difficult to raise a Series A round because so much of the equity is allocated already.

Convertible notes can have an effect on IRC 409A valuations too.  Tax and accounting guidelines require that a valuation firm, such as Teknos, look at the value of the company implied by a recent financing.  When we value of a company with a convertible note in its capital structure, we treat the convertible note as “equity,” not as “debt”; that is, we assume that the note will be converted, not repaid.  This matches the expectations of the issuing company and the investors which both anticipate that the note will convert.  (The only exception is when a company is sold before the Series A is raised, in which case the acquirer will repay the note to get the investors to approve the sale.)

A typical preferred stock financing sets a clear present value for a company (and, by implication, for common stock too).  But a typical convertible note does not provide the same clear valuation guidance.  Some notes contain a “cap,” which is essentially a “not-to-exceed” upper limit on a future value.  In that case, we have no alternative but to treat the “cap” as the value indication and to work backward, through a Black-Scholes option model, to calculate an implied value of the company and the common stock – even though this work will result in a suggested future value for the common stock too.

While we can take a large discount for lack of marketability and make a few other adjustments, sometimes the result is a value for common stock – and a strike price for new stock option grants – that is higher than the real economic value of the company today (e.g. imagine a recently formed company with no product created and no customer traction, valued using the convertible note “cap” of $10 million).  This is another reason to be careful in using and setting the terms for a convertible note financing.  Feel free to consult with us before finalizing terms on a convertible note because we often can suggest small changes which will lead to a better 409A outcome.

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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