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How Lower Valuations Can Sweeten the Deal for Employees

Posted in Business Valuation, on Oct 2023, By: Mark S. Gottlieb

Twitter, or “X”, taken private after Elon Musk’s $44 billion acquisition just over a year ago, is now valued at only $19 billion. A new internal memo is cited offering employees restricted stock units (RSUs) at a share price of $45.

When private companies offer stock-like compensation options, the IRS advises them to use a 409A valuation – an independent assessment of how much a company is worth. These appraisals tend to be more conservative than valuations based on recent funding rounds or offers from potential acquirers, for example.

X itself is “still negative cash flow,” Musk shared in July, citing a “50% drop in advertising revenue plus heavy debt load”. So, it’s not unsurprising that X’s 409A valuation came in lower than the $54.20 per share that Musk paid to take the company private. Because of this conservative approach, it’s common for companies’ 409A valuations to come in lower than their previous private market valuations. Last year, Stripe and Instacart saw their valuations slashed by 28% and 38%, respectively after new 409A appraisals.

There are a few reasons why private companies incentivized by employee stock compensation may actually prefer to have lower 409A valuations:

  • Lower strike prices on stock options give employees more potential upside and incentive to join and stay.
  • With a lower valuation, the same number of shares granted or optioned to employees represents less dilution percentage-wise for existing shareholders.
  • Companies can reduce stock-based compensation expenses with a lower 409A valuation.
  • Employees only pay taxes when they exercise options, so lower grant prices postpone taxation until shares hopefully appreciate.
  • More potential upside for employees if the stock takes off means better talent retention.
  • Lower valuations can also attract strategic investors looking for value rather than just high-growth prospects.

While founders and early investors typically want to see sky-high valuations to maximize their stake, lower initial valuations aligned with 409A appraisals can make more sense for companies relying heavily on employee stock compensation. The 409A valuation allows more room for upside to incentivize and retain talent.

While 409A valuations are essential for regulatory compliance and are a good starting point, they may not capture the full complexity of a company’s financial health. In more complex cases, such as mergers, acquisitions, or significant financial shifts, businesses should seek comprehensive reports from business valuation experts to gain a more comprehensive and holistic assessment of their value.

Schedule a call today to talk about your next business valuation case with our team leader, Mark S. Gottlieb, CPA/ABV/CFF, CVA,CBA, MST.