On May 18th, two famous, photogenic Olympians found themselves almost $300 million richer. A banner day for anyone, and yet they may have felt at least a twinge of regret. Why? They contend that 409A should have made them much richer, to the tune of as much as $1.2 billion.
At this point, Hollywood has made the story almost old-hat. In December 2002, then Harvard students Tyler and Cameron Winklevoss had an idea. They would develop a web site that connected Harvard students. If successful, they would expand the concept to other campuses. In November of 2003, after several false starts, the Winklevoss twins retained the services of a young, talented programmer to implement their vision. Three months later, without the knowledge of the Winklevoss twins, Mark Zuckerberg gave birth to Facebook. After a successful run at Harvard, the social networking site spread to other campuses, and then took over the world.
In 2004, the Winklevoss twins (and their company ConnectU) filed suit against Facebook, claiming that Mark Zuckerberg had copied their social networking ideas and source code and used them to create Facebook. In 2008, the parties settled, reportedly for $65 million – $20 million in cash and a specified number of shares of Facebook. The problem was the valuation of Facebook stock at the time of the settlement.
Around the time of the settlement, Microsoft made an investment in Facebook. This investment valued Facebook at $15 billion. The Winklevoss twins apparently used this valuation, with a per share price of $35.90, when determining that the number of shares provided as part of the settlement.
How does 409A come in to this story? Like many illiquid startup firms, Facebook made substantial option grants to its employees. For an option to be exempt from Code Section 409A, the option must be granted with an exercise price no less than the fair market value of the underlying stock on the date of grant. Most private start-up companies, particularly ones growing very quickly, regularly engage experienced valuation firm to establish the Company’s fair market value for 409A option grant purposes. Facebook was no exception. In fact, Facebook had come up with an $8.88 per share 409A valuation shortly before the settlement.
After learning of the 409A valuation, the Winklevoss twins sought to invalidate the settlement agreement. Among other things, the twins argued that Facebook’s failure to disclose the $8.88 409A valuation constituted fraud. Had Facebook disclosed the 409A valuation and had that valuation been used in the settlement, the twins would have ended up with more than four times the number of shares they actually received.
Ultimately, the twins lost their appeal to invalidate the settlement, which, after Facebook’s recent IPO, left them with stock purportedly worth around $300 million. Had they used the 409A valuation at settlement, however, their settlement stock could have been worth as much as $1.2 billion.
What’s the moral of this story? Private company stock valuations are inherently speculative, and can be appropriated for purposes other than that for which they are intended. For private companies that issue stock options, 409A can create a paper trail of valuations that can at least raise issues for potential investors, employees, and litigants. Prudence may dictate that companies clearly qualify the limited purpose for which a 409A valuation is obtained (i.e., compliance with 409A). Further, it may be advisable to include confidentiality provisions in stock option agreements and to take such other measures as are necessary to keep private company 409A valuations … well, private.