Venture Capitalist at Theory

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3 minute read / May 24, 2019 /

Before You Raise a Round of Funding, Ask Yourself This Question

Before you raise your next round, ask yourself this question. Are there any key people you need to hire? Essential executives, critical engineers, important managers or anyone else? Your common stock value, or 409a valuation will increase the second you receive a term sheet. And the strike price of any new options will increase with the 409a valuation.

Let’s take a step back. When you hire someone, you’ll grant them a salary and options. An option is the right to buy shares of the business at some future point in time. The strike price of the option is equal to the value of the common stock, which is set by the company’s board periodically, based on a report by an independent appraiser, the 409a valuation.

During the early stages of a company, the board typically ratifies an updated 409a valuation annually. As the company grows and approaches an IPO, the company sets 409a valuations more frequently; starting bi-annually, then quarterly, then monthly. The 409a valuation should converge to the price of a share at IPO because the value of exercising an option at IPO should be zero, since you could just buy the share in the public markets at that price through your broker.

The greater the strike price of an option, the smaller the upside. If I offer you an option to buy a share of a business at $0.01 and in ten years, the share is worth $15, your upside is $14.99. If I offer you that same option at $10, your upside is $5. I’m ignoring taxes here.

Significant events in a company’s life will affect the 409a valuation. If the company meaningfully beats its plan, the valuation may increase. If public market multiples increase in value, so will the 409a. If the company completes a secondary transaction, the 409a may be impacted. The most common significant event affecting the 409a valuation of an early stage company is receiving a a term sheet for a new financing.

A term sheet to finance the business or acquire the business means a third party has valued the business. That term sheet will be considered as part of the next 409a valuation process. If you receive a term sheet, you must wait until the next 409a to issue options and their strike price will be the new, higher 409a price.

To maximize the value of the options to new key hires, hire them before you raise your next round. There could be a material change in the value of those options to your hires. It’s also a great tool to drive urgency in the hiring process.

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