Why Convertible Notes effect on IRC 409A Valuation?

About 409A Valuation

The market can decide the market value of a share in public companies, whereas private corporations must rely on an independent appraiser. A private company can’t provide equity without knowing the value of each share. They need a 409A valuation. A 409A valuation is an independent appraisal that finds the value of the fair market value per share of common stock. 409A valuation is enacted by IRS Section for the federal income tax purpose.

Important to whom?

409A valuation is important as it will protect the employees from any tax issues that might arise in the future. It is important to the companies as well as to the employees and investors. A 409A valuation gives the acceptable fair market value of the company’s shares and gives safe harbor protection.

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Safe Harbor: A safe harbor is a legal provision where it is presumed the fair market value should be reasonable and met with IRS tax rules and regulations so that employees can avoid or eliminate the regulatory liability if certain conditions are met. The conditions are 409A valuation by independent appraisal or by a third party then they will be accountable and answerable for the value of a company.

When does a company need to do 409A Valuation?

1. Once in every 12 months
2. When a company is going to raise funds or after fundraise
3. After a major material event. If a company is approaching for an IPO, Merger, or Acquisition

There are different kinds of debts treated in IRC 409A valuation in which convertible notes is also one of them which have to evaluate in 409A valuation. So, you’ve probably heard of convertible notes, which have become a popular and regular way for businesses to raise funds.

Let’s take a look at convertible notes and how they affect IRC 409A valuation.

Convertible Notes:

Convertible notes are short-term debt investments with the option to convert the principal and accumulated interest into equity at a later time. This allows the original investment to be completed faster with lesser legal expenses for the firm at the time, while still providing the investors the economic exposure of an equity investment. 

In recent years, many small companies have utilized convertible notes instead of preferred stock to raise money from angel investors and venture capital firms. The convertible notes may have a valuation cap (e.g. the notes will convert at $2 million) or a discount (e.g. the notes will convert at 70% of the Series A price per share). Convertible notes are used to raise $1 million or less than $1 million as it is a debt that was raised for the Series A round.

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Why convertible notes should be properly structured?

Convertible notes are easy and inexpensive to create for fundraising. And they are attractive for investors since they defer the tough task of evaluating a new firm in its early stage. But on the other side, if the notes aren’t correctly structured they might make it harder for a business to secure the next round of investment.  

According to the investors, convertible notes may cause a firm to obtain too much startup money and raise too much seed money that can make a Series A round difficult because so much equity is already allocated.

Can convertible notes affect IRC 409A valuation?

Yes IRC 409A values can also be affected by convertible notes. When a valuation firm does the valuation of a company, then it has a convertible note in its capital structure and they evaluate it as “equity” rather than “debt,” assuming that the note will be converted rather than repaid. This corresponds to the expectations of both the issuing company and the investors, who expect the note to convert. The only exception is if a firm is sold before Series A is raised then in that case, the buyer will return the note to gain investor approval.

On the other hand, a normal convertible note does not give the same level of clarity in terms of valuation. A “cap” which simply means “not-to-exceed” upper restriction on a future value, is found in some notes. In such circumstances, there is no choice but to use the “cap” as a value indicator and work backward, using a Black-Scholes option model, to compute an implied value for the firm and the common stock – even if this work will also result in a projected future value for the common stock. 

A valuation firm can use a large discount for lack of marketability (DLOM) and a few additional modifications to arrive at a value for common stocks and a strike price for new stock option grants that are greater than the company’s current true economic worth. For e.g. consider a newly formed company with no product and no customer traction, valued using the convertible note “cap” of $8 million.