How an investor term sheet impacts a 409A valuation report is a question we get from founders every week.
Depending on the specific facts, this situation can be difficult. When you have promised (but not granted) options and an attractive term sheet with a massive valuation has unexpectedly shown up, there are some issues to sort out.
It happens. Don’t panic.
Let’s get the nuances under our belt so we can understand how term sheets impact 409A valuations, with the goal of finding an optimal solution for everyone.
To understand how term sheets impact 409A valuations, talk to real experts.
You must work with an experienced valuation expert to think through the nuances and potential solutions.
By experienced I mean a valuation specialty firm utilizing experienced professionals to perform the 409A valuation report and support the analysis upon any challenge.
A software- or algorithm-based approach will not suffice here (such “automated” approaches are prohibited by professional appraisal standards). It is a mistake to think that this is optional.
Discussing with an experienced valuation expert is the first step in understanding how term sheets impact 409A valuations.
A 409A valuation is a process for appraising a business to determine the fair market value of its common stock.
It is required by law for companies that are planning to issue deferred compensation to their employees, such as stock options or restricted stock units. The 409A valuation report is used to set the strike price of the options or the purchase price of the restricted stock units.
409A valuations are important for several reasons:
They ensure that companies are complying with the federal tax code.
They protect companies from IRS audits and penalties.
They provide investors and management with a gauge of the company’s financial standing.
A 409A valuation report is required whenever a company grants equity compensation to its employees, unless the company has a safe harbor valuation in place. A safe harbor valuation is a valuation that is performed in accordance with the IRS’s regulations and that is presumed to be accurate.
Companies must also obtain a new 409A valuation report within 12 months of any material event, such as a significant change in the company’s financial performance or business plans.
There are several benefits to getting a 409A valuation report, including:
Compliance: 409A valuations help companies comply with the federal tax code and avoid IRS audits and penalties.
Accuracy: 409A valuations are performed by qualified appraisers using accepted valuation methods, so you can be confident that the valuation is accurate.
Transparency: 409A valuations provide investors and management with a clear understanding of the company’s financial standing.
A term sheet is a non-binding agreement that outlines the key terms of an investment proposal between a venture capitalist (VC) and a startup company. It is typically presented by the VC to the startup after the VC has conducted due diligence and is interested in making an investment.
The term sheet serves as a blueprint for the negotiation and drafting of definitive investment agreements, which are the legally binding contracts that govern the investment. The definitive investment agreements will be drafted by lawyers for both the VC and the startup and will typically take several weeks to finalize.
The term sheet will typically include the following key terms:
Valuation: The valuation of the company that the VC is proposing. This valuation will be used to determine the number of shares that the VC will receive in exchange for its investment.
Equity stake: The percentage of ownership of the company that the VC will receive in exchange for its investment.
Investment amount: The total amount of money that the VC is investing in the company.
Anti-dilution provisions: Provisions that protect the VC’s equity stake from being diluted if the company raises additional capital at a lower valuation.
Liquidation preference: The VC’s right to receive a certain amount of money back from the company if it is sold or liquidated.
Board representation: The number of seats on the company’s board of directors that the VC will receive.
Other rights and privileges: Any other rights and privileges that the VC will have, such as the right to veto certain corporate actions.
The term sheet is an important document for both startups and VCs. For startups, it is a chance to get a good understanding of the VC’s investment offer and to start negotiating the terms of the deal. For VCs, it is a way to communicate their investment proposal to the startup and to start the process of reaching a final agreement.
A term sheet on its own, however, can be thought of laying the groundwork for further negotiations, with the goal to reach final, binding agreements. It is a guide to the proposed financing.
A 409A valuation report is an independent assessment of the fair market value of a company’s common stock. It is important to note that “fair market value” may not be the same as the price per share that a company may sell its stock for in a private placement.
Instead, the “fair market value” is tax code concept and is determined based on a number of factors, including the company’s financial performance, financing history, industry comparable companies, and the current market environment.
Term sheets can impact 409A valuations in several ways. For example, the 409A valuation report may be affected by the proposed valuation of the company, the type of securities being issued, and the terms of any liquidation preferences.
One of the most common ways that term sheets impact 409A valuations is through the proposed valuation of the company.
If a VC proposes a valuation that is significantly higher than the company’s current VC valuation, this may have the effect of recalibrating the fair market value of the common stock upwards.
On one hand, this can be beneficial for startups and founders, as it can lead to higher valuations for their equity. On the other hand, many startups like to use lucratively priced stock options to recruit talent.
However, it is important to note that the proposed valuation in a term sheet is just that: a proposal. The actual valuation of the company for tax compliance purposes will be determined by the independent 409A appraiser. If the appraiser believes that the company is not worth the proposed valuation, they will adjust the valuation accordingly.
Many features of a term sheet have the potential to impact a 409A valuation report. Therefore, it is critical to methodically work through some key questions and provisions to assess the impact of term sheets on 409A valuations. Additionally, perhaps more importantly, it is crucial to understand the range of options available as potential solutions to the situation.
Here are some key nuances to assess:
Whether or not a company has signed a term sheet is paramount when it comes to its impact on 409A valuations. A term sheet is a non-binding agreement that outlines the key terms of a proposed investment between a venture capitalist (VC) and a startup company. It is typically presented by the VC to the startup after a pitch by the company. It indicates that the VC is interested in making an investment.
An unsigned term sheet, or a term sheet not yet accepted by the company’s board of directors, typically indicates an investor’s initial interest. Because it us unaccepted and unsigned, the term sheet does not yet indicate the company’s willingness to sell securities on those terms. From a 409a valuation standpoint, some / many / most (?) corporate securities counsel might be of the mind that the receipt of an unsigned term sheet isn’t a “valuation inflection” point. It’s an intent, a potential prelude to something concrete, but it’s not set in stone.
Our view here is that unsigned term sheets likely have minimal to no impact on 409A valuations. Naturally, once the company accepts the term sheet or signs the term sheet, the scenario almost certainly shifts.
A signed term sheet, meaning a term sheet that has been approved by the board and signed by the company.
Once a company has signed a term sheet, it is considered to have accepted the VC’s investment proposal. While the financing is likely to advance the development of the enterprise and increase the likelihood of its success, what is the impact of the term sheet on 409A valuations?
It is our experience that most / all (?) legal professionals view a signed term sheet (i.e., a term sheet accepted by the company’s board and signed by the company) as a “valuation inflection” point. But the inquiry doesn’t end there.
Sure, the term sheet is signed and accepted. But is it legally binding? Is there a due diligence out? Is the deal likely to close? Your company’s IRC Section 409A FMV could swing significantly based on this factor, emphasizing the need for clarity on these important terms. Therefore, depending on the terms, even if it is signed, there may be no impact of term sheets on 409A valuations.
Again, it can’t be overemphasized that you must talk to knowledgeable corporate / securities counsel and find an experienced valuation expert (a real, human expert, not a software company using algorithms). It is critical to get up the curve on the nuances of this critical point to properly understand the menu of solutions available to you.
One of the most important factors to consider when assessing the impact of a term sheet on a 409A valuation report is the status of deal documentation.
Deal documentation typically includes definitive transaction agreements, which are the legally binding contracts that govern the terms of the VC investment. It is important to understand where on the continuum from “not started” to “complete” the deal documents sit because deal documentation frequently signals the potential deal’s status and evolution.
If the deal documents are complete or in an advanced negotiation stage, this suggests that the deal is close to closing.
In this case, it is reasonable to assume that the VC is committed to the investment and that there is a low probability of the deal falling through. This proximity to closure is likely to have a material impact on the 409A valuation.
On the other hand, if the deal documents are still in their infancy, this suggests that the deal is still in its early stages. In this case, there is a greater likelihood of changes, adjustments, or even the potential for the deal to fall apart. Because of this, the probability of getting the deal done at this stage is likely at its lowest.
The uncertainty at this stage can introduce volatility and should be taken into consideration when assessing 409A valuations. This reasonably distant proximity to closure suggests that on a probability-weighted basis, the impact of the term sheet on a 409A fair market value is at its lowest.
As a result, the status of deal documentation can have a significant impact on the outcome of a 409A valuation. Startups and founders should be aware of this when negotiating term sheets with potential investors.
How the Status of Due Diligence Based on a Term Sheet Impacts FMV & 409A Valuations
One of the most important factors to consider when assessing the impact of a term sheet on a 409A valuation is the status of due diligence.
Due diligence is the process by which a venture capitalist (VC) investigates a startup company before making an investment. The VC will typically review the company’s financial statements, business plan, and management team.
If due diligence is complete and the VC is satisfied with the results, this is a strong indication that the VC is committed to the investment. In this case, the 409A valuation report will likely be reflective of the proposed valuation in the term sheet. On the other hand, if due diligence is pending or inconclusive, it can introduce uncertainty, potentially causing hesitation or even termination of the potential deal.
If due diligence is not complete and the VCs have a due diligence “out,” some measurable likelihood of the VC financing falling apart exists. This also adds up to reasonable distant proximity to closure, suggesting that on a probability-weighted basis, the impact of the term sheet on a 409A fair market value is not at its maximum.
Eton Venture Services was founded by veteran Silicon Valley lawyers and includes a team of CPAs and CFAs who were trained by the ‘Big Four’.
Valuation and valuation advisory is our sole focus, meaning that our experts are independent and unbiased, with no conflicts of interest. Our customized solutions, tailored reporting, and flexible pricing options ensure that private companies receive the highest level of service and value.
Hundreds of companies have trusted Eton to provide rigorous, audit-defensible, and optimized IRC 409A and ASC 718 valuations to assist in attracting, retaining, and incentivizing top talent while remaining in compliance with the law.
Our team will work with you to ensure that your company’s financial reporting is compliant and that your IRC 409A FMV report accurately reflects the fair market value of your common stock and any impact to it from the receipt of a term sheet for preferred stock financing.
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Chris co-founded Eton Venture Services in 2010 to provide mission-critical valuations to venture-based companies. He works closely with each client’s leadership team, board of directors, internal / external counsel, and independent auditor to develop detailed financial models and create accurate, audit-proof valuations.
