COVID-19 Crisis, Stock Options & 409A Valuation: An opportunity to realign the sharing of long-term value?

The COVID-19 pandemic continues to send financial markets globally in a tailspin. The economic slowdown will undoubtedly affect the technology startup and venture capital ecosystem. As per IRC 409A provisions, a valuation report is valid up to 12 months from the valuation date or the date of any significant event that can impact the valuation materially, whichever is earlier. Can COVID-19 be identified as one such event?

Amid the ‘We Work’ implosion and lackluster IPOs of Uber and Lyft, the COVID-19 crisis will further force venture capitalists to think harder about the road to profitability, which may impact the volume of mega-rounds in 2020. With no clear visibility on how long the situation will continue, prolonging social distancing protocols and lockdowns, even early-stage funding deal activity may decline perceptibly in the short term.

From the valuation standpoint, the degree and scale of economic uncertainty can qualify as a ‘significant event’ for practically any company at this point. Hence, companies granting equity compensation in the near future must consider the valuation implications of COVID-19.

The impact of this disruption may vary across different emerging technology verticals. Companies in sectors such as travel tech are the worst hit and will likely face an unprecedented challenge in terms of survival amid a major shift in consumer behavior. The long-term economic damage that the crisis may cause and knock-off impact that it could have on businesses is a complicated question with no clear answers yet.

Companies in industry verticals most impacted may be forced to take harsh measures, including layoff or salary cuts, creating challenges with regard to employee morale and the ability of the company to retain key talent. Such crisis also presents an opportunity for management teams to realign the long-term interests of their key stakeholders. A prudent move to achieve this objective could be to compensate employees with stock options.

The current market situation provides enterprises with an opportunity to conduct new valuation and set the strike prices of the stock options they expect to grant to employees within the next 12 months at much lower and attractive levels. Companies may also consider cancelling previous grants at much higher strike prices and offer new employee stock option grants at advantageous strike prices.

On the other hand, if your company’s business prospects have improved greatly during the crisis (like for companies working in technology verticals, offering remote working solutions), you may be running the risk of granting discount options.

Startup valuations are inherently subjective, and a company may prefer to do its 409A valuation internally, especially if it is in mid-to-late stage with highly qualified CFO or controller. However, internal valuation shifts the burden of proof from the IRS to your company.

Despite several constraints, a credible valuation is possible. Pursuing a proactive approach to understanding the analysis and accordingly preparing a well-documented valuation report can be a rewarding decision. In short, this is an excellent time to connect with your valuation firm.

During the last financial crisis, the US venture capital industry displayed a level of resilience that was impressive to say the least, evolved, and went on to consistently achieve new record-breaking levels. We hope the startup ecosystem will evolve and emerge from the current economic disruption as well.

Aranca’s valuation professionals can help your company determine if you need to update your 409A valuation. With strong capabilities in market research, Aranca has expertise in assisting global companies understand how business drivers are interlinked with industry trends shaped by events, including disruptive changes.