Many companies, especially technology startups, motivate employees by aligning their incentives with the growth of the business. One of the most common ways is by using Employee Stock Option Plans (ESOPs), in addition, to bonuses, travel and food incentives.
As it relates to valuation, there are couple of best practices for management to follow:
Firstly, a well drafted shareholders’ agreement by the firm’s legal advisors, along with input from the firm’s accountant and business valuator, should greatly assist in avoiding possible inconveniences, in the future. The range of key valuation specific issues are as follows:
- Repurchase clauses – Cliff structures are common for some founders in certain startup entities; furthermore, clauses can be added to repurchase employee’s shares on termination.
- Share Valuation clauses – Entities, typically, settle between a Business Valuation or a Fixed Formula Valuation, per the shareholders agreement. The nuances of which have to be agreed upon, including definition of value, discounts, timing, business valuator to retain, ability to modify the fixed formula as the company evolves etc.
- Intellectual property clauses – Depending on the level of control exerted by the management (Refer to our previous post, which outlines certain benefits that majority interests enjoy relative to minority interests), intellectual property developed by management either belongs to the company or to the founder. In many cases, this can have a huge impact on valuation.
- Preemptive right clauses – Providing the option to current shareholders / investors, this clause motivates the current participants to add more value as the stakes rise, upon new capital inflows.
- Liquidity Event clauses – Popular clauses such as ROFRs, Tag along/drag along, and shotgun clauses, often, assist in liquidity events and in the event of a shareholder dispute.
While it may seem to some that there are quite a few considerations to work out and the cost/benefit might not make sense, for all; employee stock options typically have many unique characteristics and are often utilized to recruit management and key employees, while aligning interests.
The ESOPs vest, typically, over a three year period depending on the entity and the industry. Additionally, the ESOP’s are usually the only form of ownership that an employee other than a founder or key management retain interests in. As such, most ESOP holders have a minority shareholding interest in the organization, that they are involved with, and this interest either appreciates significantly or is worthless, depending of the performance of the start-up entity.
We note that many valuations that we have seen use shortcuts, i.e. financing rounds, to arrive at their equity value (pre and post valuation); we do not disagree with that as a circular approach, at times, is used to check the reasonability of the valuation – i.e. for 409A valuations. Sometimes, liquidity events (acquisition, sale etc.) give rise to tough management decisions i.e. should founders and management sell the company at the current price and is it fair market value for the shares or consider alternatives?
In either case, we are trained and experience to perform 409A / ESOP valuations for founders, management and shareholders, along with advising on whether to accept any offers for their minority or majority shares in an entity and, for what purchase price? Price and value are often different and many founders, technology managers and owners are trained and experienced in their industry and, often, require advise when evaluating all offers presented to them.
At Minerva Valuation Advisors, we are trained, as business valuators, appraisers, mid-market bankers and financial analysts, in a variety of settings including in tax planning valuations, family law valuations, shareholder disputes valuations and merger & acquisitions valuations and advisory. We are not your typical business valuator or appraiser, as we attempt to connect the dots using a variety of perspectives to give you some of our best insights.