Valuing Common Stock in a Startup — Where the Accountants are the Optimists

I have just gone through a very bizarre experience where I, the entrepreneur, somehow became more pessimistic than my accountants about my company’s prospects. Usually the entrepreneur is the one who paints the picture of the future that leads to riches for everyone — where despite the lack of present cash, revenue, product (or any one of the above), the future has never looked brighter. And I am as fervent as they come.

But somehow, I became the pessimist and my accountants, the optimists.

It is all about a new IRS regulation called 409 A. The IRS insists on having independent auditors perform a valuation on the company to value common stock in order to determine a reasonable option price that is set based on this valuation. Whereas the entrepreneur would like to see an option price as low as possible to create as much incentive as possible to potential hires, the IRS and their accounting legions, wish to see a common stock price valued at market value and the option price closely approximating it.

The accounting sages do allow for discounts to the option price based on concepts like participating preferred clauses but they do not take into account the following logical concepts:

  1. That the pricing of the venture money (pre-money valuation) is subjective and has no direct market value.
  2. They do not take into account the success ratio of most startups. They do not take into account the likelihood that the startup will likely fail (at least statistically).
  3. They do not comprehend the value of low priced options to recruit employees. By forcing us to price our options close to the common stock price, the spread is necessarily small as is the attractiveness of the option.

Granted the excesses in the option pricing past needed to be rectified. But in typical governmental fashion, our accounting sages have gone to the other extreme (Sarbox anyone) and reduced the value of one of the few financial incentives we CEO’s have (beyond our flashy personalities) to recruit top talent.

Of course, the size of the spread is meaningless if the company fails or is sold for change. But an option price of $.1 is very different than $.70 , especially when with typical IPO prices of $10-15.

Give us a break. Let us hire great talent, build great companies and fill the tax coffers with our capital gains. The cost (easily 5K/year) for these valuations and the negative impact on our employees is burdensome and very unhelpful.

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