By: Hye Jin Koh
A 409A valuation is a determination of the fair market value (FMV) of a private company’s common stock, often used to set the strike price for stock options granted to employees. The process requires a reasonable valuation method to be conducted in good faith. A material change, for the purposes of 409A valuations, is any event that could significantly impact a company’s valuation, rendering the previous 409A valuation outdated or stale.
When a company closes a priced equity offering under Reg CF, a new 409A valuation is generally recommended. This is because Reg CF offerings often represent a material event due to the influx of new capital and potential shift in the company’s risk profile and growth trajectory. Obtaining a new 409A valuation ensures compliance with the Internal Revenue Code Section 409A, which governs nonqualified deferred compensation plans. These plans, such as stock option plans, are commonly used to attract, retain, and incentivize employees, advisors, and consultants by offering them the opportunity to purchase company stock at a predetermined price. Issuing equity awards under these plans with a stale 409A valuation could lead to significant tax penalties for both the company and the recipient.
Determining whether a new 409A valuation is necessary after a Reg CF offering depends on whether the offering qualifies as an “orderly transaction.” This concept is crucial in assessing whether the offering price can influence the company’s FMV for 409A purposes. An “orderly transaction,” as defined by the Financial Accounting Standards Board (FASB), involves sufficient market exposure to allow customary marketing activities, such as investor due diligence and engagement with company management. Private financing transactions typically meet these criteria if: investors have adequate time and resources to evaluate the company’s financial and strategic position; investors can engage directly with company leadership to address concerns and understand the company’s strategy; comprehensive and reliable company data is accessible to investors; and investors can meaningfully negotiate the offering price. Crowdfunding platforms, however, often do not facilitate robust due diligence, meaningful negotiations, or direct engagement with management. Consequently, Reg CF offerings may not inherently meet the standards of an “orderly transaction.” Key factors to evaluate include whether the platform enables thorough due diligence by investors, whether detailed company information is readily available to potential investors, whether participants have the sophistication to assess the investment, and whether the investors are able to influence the offering’s terms.
The unique characteristics of the Reg CF offering must be carefully reviewed on a case-by-case basis. While a new 409A valuation is generally recommended after such an offering, the specifics of the transaction—especially whether it aligns with “orderly transaction” standards—may inform whether this step is strictly necessary.