In Part 1 of this article, I discussed how starting a country, as the Founding Fathers did in 1776, shows similarities to starting a company in 2018.
For those of you who wish to read (or re-read) Part 1, here is a link: http://melioraadvisors.com/valuation/the-founding-fathers-didnt-have-to-worry-about-409a-valuations-part-1/
It wasn’t enough to simply say “We hold these truths to be self-evident…“, the FFs had to actually go out and make it happen and there was a powerful empire looking to stop them. There were 56 signers of the Declaration and it would literally require an army to make their vision a reality. Quite a challenge for HR – and when facing Redcoats pointing muskets and bayonets, patriotism only goes so far. Soldiers need to be fed, clothed, and paid but when you’re just starting out as a country or company, where do you get the money? The Revolutionary War was paid for through a combination of borrowing, currency printed by the 13 colonies, currency printed by the Continental Congress, and other sources.
The similarities are obvious. Startup companies raise debt (banks, friends and family, credit cards, etc.), equity (venture capital, angel investors, etc.) and they “print” their own in the form of options and warrants. Just as Continental currency would be worthless if the colonies lost the war, options, warrants and equity are worthless if the company fails. So attracting an “army” to work at or fund a fledgling startup is a tough job. Making sure that the options, warrants and other “self-created currency” are structured and valued correctly is the job of attorneys, accountants, and valuation professionals.
These are startup companies. They have no money for this sort of thing and the IRS hasn’t the resources hunt them down if they don’t conform to IRC Sec. 409A. Well… that’s not the point.
Like the United States in 1776, startups face a “binary” situation. Either they make it or they don’t. If they don’t make it past next Tuesday, nobody will care about this and it’ll be just another company (or revolution) that was crushed under the boot of competition (or an empire). But what if they DO succeed? What if this turns into the “industry disruptor” that the founders, VCs, Banks, and employees hope it will be? NOW there is much to lose if this all goes haywire and it is very hard to go back and fix the past (and perhaps, THIS is when the IRS will knock at the door).
Successful VCs thrive in a risky world but they HATE risk. VC’s ONLY make money when the VC exits via the sale of its position (to a financial or strategic buyer, or in much rarer cases, via IPO). ANYTHING that might prevent that from happening presents a major headache for VCs. Some risks can be mitigated and some cannot. Having books that are correct and follow all the intricate rules is one that can be handled by people who are trained to handle it.
Buck Jordan, veteran venture capitalist, founder of Canyon Creek Capital and founder and Managing Partner of FUTURE, a venture fund and corporate incubator in Los Angeles, has seen all of this first-hand. “I’ve seen where options had to be re-priced because nobody paid attention [at the beginning]…I’d rather spend the money for a 409A valuation back then than have to have a difficult board conversation later…plus there are fiduciary and personal liability issues at the board level and absolutely no one wants that.“
Nearly all of the calls I get to perform 409A valuations come from attorneys and VCs. Buck isn’t surprised and says “founders are focused on getting a round closed and growing the business and they are not hyper-concerned with getting [things] in order. Also, founders are generally first or second time entrepreneurs and don’t know what they don’t know. VCs and lawyers ask for these valuations because they see these situations over and over“
Certainly, the FFs had a lot to lose if the venture failed. Upon receiving the Declaration, King George ordered his soldiers to find and execute the 56 signers, putting an end to the “foolish rebellion.” Founders, and their VC partners are in a far better, albeit leaky boat. Anything that causes a deal to fall apart during due diligence would be a disaster and smart buyers are more rigorous in their analyses than ever before. Simply stated, there’s too much at stake to simply say “so what“.