Impact of Market Volatility on 409A Valuations

If your company has an urgent need to hire talent, you might actually welcome market volatility with arms wide open. Why? Well, market volatility can reduce valuations. Investors will be uncertain about your company’s value and they will want a better risk premium for their funds. But, if you issue stock-based compensation at this point, the potential gains for your employees will be quite significant.

In this article, we will discuss this very idea, the impact of market volatility on 409A valuations, i.e. valuations for issuing stock-based compensation. We will also test the theory by plotting 409A valuations against the CBOE Volatility Index (VIX).

What is market volatility?

Market volatility refers to uncertainty in asset prices. The type of market volatility that typically affects 409A valuations is volatility in equity markets, which is what we will focus on. Events like health crises, geopolitical tensions, and supply chain breakdowns can cause a spike in market volatility. In such a period, the expected range of stock price movement widens.

If you are from the US, you may have heard about the CBOE Volatility Index (VIX Index) which is calculated based on real-time, mid-quote prices of S&P 500 Index call and put options. The VIX Index indicates the amount of volatility expected in the next 30 days in the US equity market by traders.

When the VIX Index rises, it means that market volatility has risen, i.e. traders have become more uncertain about stock prices. The opposite is also true. When the VIX Index falls, it means that the market volatility has fallen, i.e. the traders have more conviction about the stock prices.

If we look at VIX Index figures since 1990, the index reached its peak of 89.53 on 10^th October 2008, popularly known as the ‘Bloody Friday.’ On this day, the S&P 500 fell 3.5%, the London FTSE fell 5%, the Japanese Nikkei fell almost 10%, and the Moscow market fell 14% before suspending trading. This was the onset of the Great Recession.

Source: Chicago Board Options Exchange (CBOE)

If we look at the data since 2019, the highest closing value for the VIX Index was on 16^th March 2020. On this day, the markets realized that we were in for a prolonged battle against COVID-19, and as a result, the S&P 500 fell 12% and the Nasdaq fell 12.3%.

Typically, when the VIX Index rises, we can expect a fall in equity prices.

What are 409A valuations?

When you issue compensation in the form of equity to your employees, their gains will be based on your company’s valuation. So, the Internal Revenue Service (IRS) will be interested in knowing the valuation at which the equity was offered as that affects the amount of tax they can collect. In the Internal Revenue Code (IRC), Section 409A dictates the treatment of deferred equity compensations. A 409A valuation is simply a valuation that complies with this section of IRC.

Broadly speaking, the purpose of such valuations is to determine the fair market value (FMV) of your company’s stock. The FMV is the price acceptable in a market that knows and understands your company.

The lack of speculation and bias in 409A valuations is what differentiates them from stock market valuations and fundraising valuations.

In the stock market, traders may act out of panic, have a negative bias about a particular industry, or they may be overly optimistic about a company and ignore certain indications of weakness.

When a startup raises funds, the valuations depend a lot on the company’s growth potential, the image of the industry segment, and the negotiating power of each party.

However, 409A valuations must not stray from the fair market price because of such biases, speculation, or prejudices.

How does market volatility affect 409A valuations?

By definition, 409A valuations have no room for impurities like speculation, biases, and prejudices. So, 409A valuations are typically lower than fundraising valuations since they do not speculate about the company’s growth potential.

So, you would expect that 409A valuations will not drop like fundraising valuations do when market volatility increases. But, you would only be half right. It is true that when market volatility increases, the expectations of growth drop, and thus, fundraising valuations drop. Since speculation about growth potential is not included in 409A valuations, they will not experience a drop because of this reason.

However, this is not the only reason why fundraising valuations drop when market volatility increases.

When market volatility increases and we see an evident rise in the VIX Index, it instills a fear of a market crash. So, investors will pull their money from riskier assets and put them in safer assets like gold and government bonds. This is known as a flight to safety. It results in a drop in funds available for high-risk, high-return assets like private equity.

When funds are in short supply, investors can charge a higher premium. They will have more negotiating power to drive the entry valuations down in the private equity market.

Let us summarize.

• Prices based on 409A valuations are the prices acceptable in a market that fully knows and understands your company
• When market volatility rises, funds will be in short supply and will attract a higher premium
• Acceptable prices in a market drop because investors have more negotiating power
• 409A valuations will also drop even though they did not consider the companies’ growth potential to begin with
• Since 409A valuations are dropping only because of scarcity of funds, they will fall less than fundraising valuations which are also falling because of altered growth expectations.

Historical evidence

As per our hypothesis, market volatility should have a limited impact on 409A valuations compared to fundraising valuations. Also, rising market volatility will cause a reduction in 409A valuations. Let us test that theory!

For this purpose, we will compare Eqvista’s 409A Valuation Index and CBOE Volatility Index. While our index includes data across sectors and stages and also records highs and lows in addition to median values, we will focus on medians of 409A valuations of startups from the pre-seed to Series C stage.

Plotting this data gives us the following graph.

Observations:

• No significant movements in 409A valuations were seen as the quarterly average VIX Index shot up in Q1 2020.
• As the average VIX Index figures fell gradually from Q1 2020 to Q4 2021 (highlighted as green on the chart), median 409A valuations rose at pre-seed, Series A, Series B, and Series C stages.
• As the average VIX Index figures rose from Q4 2021 to Q4 2022 (highlighted as the red area), median 409A valuations fell at pre-seed, seed, Series A, Series B, and Series C stages.
• The average VIX Index has continued falling since Q4 2022. In the same period, we can see a slight uptick in 409A valuations across stages.

Key takeaway:

• Based on these observations, we have verified the inverse relationship between market volatility and 409A valuations. 
• 409A valuations in volatile markets follow a downward trend. 
• We can also note that the reaction of 409A valuations to market volatility is milder than equity markets or fundraising valuations. 

So, we were right in thinking that since growth potential is not considered, 409A valuations will be less affected by market volatility. 

Leverage Eqvista’s 409A valuation expertise

Market volatility rises when the market is uncertain about future asset prices and falls when the market has conviction in future asset prices. In equity markets, we have observed that the biggest spikes in market volatility happened when markets suffered historic crashes. A rise in market volatility affects fundraising valuations by altering growth expectations and letting investors charge a higher premium as funds become scarce.

On the other hand, market volatility affects 409A valuations only because investors are charging a higher premium for funding.

Eqvista was able to draw such valuable conclusions about 409A valuations and their relationship with market volatility because of our extensive experience, and capabilities in research and analysis. If you would like well-researched 409A valuations, contact us on this page!