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409A as a Service: Cash Cows Get Slaughtered (siliconhillslawyer.com)
194 points by pdq 815 days ago | past | web | 54 comments

God this is an insanely good idea. Not only do you solve a real pain point for startups (the whole 409a eval) but if they sign up and feed you monthly updates on their financial position you could massively front run the market on what startups were going to pop and which were going to expire quietly. Google thinking about acquiring your startup? Lets have a look at the other six companies in your space for which is the right one to grab and for how much. Ka-CHING!

Hello -- founder of Preferred Return (the valuation firm behind this offer that is partnered with eShares) here. As appraisers we cannot own equity or any economic rights in the companies we value.

That makes perfect sense, but it isn't owning equity in the companies that is valuable, rather it is the knowledge of both the current value and change in value of a material number of startups in a particular space.

Today there are a number of research companies that use this exact same information, as reported by public companies as part of those company's obligations to the SEC, to evaluate investment risk and opportunity. Their services go from 'free' (as in Charles Schwab will send you a copy of their research department's report on a company or a segment if you're an account holder) to 'extortionate' which some of the larger trading houses keep in their back pockets to help them pick winners and losers.

As a collection point for this information about privately held companies, it puts you in a nearly unassailable position to do research on which of these companies are likely to be successful or not (your own sort of buy/hold/sell ratings) This isn't even possible today because, as the article mentions. everyone goes to different places to get their 409A valuations. So no single entity has enough of the puzzle to assemble a recognizable picture, yet by offering this valuation service, and attracting a very large number of customers, you create the opportunity to be that single source of information.

I would venture a guess that there are venture capitalists that would pay handsomely for a 'peek' at the state of the industry 'yet to come' as it were. That would not involve you (Preferred Return) owning any equity in any company, all you'd need to do it offer up research reports at $500,000 a copy describing the state of the industry :-)

I am in awe of how amazingly clever this whole scheme is!

Because we want to continue to run a respectable business, and staying in business depends on our clients trusting us, we have no incentive to pursue a data-based revenue model. We are a service provider, like an accountancy or a law firm, not a software or data company.

To do what you propose would involve trading our large, primary revenue stream for an untested one-shot reporting product that would be extremely unpopular with everybody and put us out of business overnight. It makes little sense to me. You draw analogies to public markets, but there's a reason private companies are called private companies.

In addition to our standard engagement terms that forbid such use of client data, we are happy to sign customer NDAs and regularly do so. We have never earned a cent from client data and have no intention of doing anything of the sort.

Happy to discuss over the phone if you have any further suggestions on this front.

Pendevere, email me. Address is in my profile.

> As appraisers we cannot own equity or any economic rights in the companies we value.

I don't think Chuck was referring to you personally, since that would be a magnificently foolish thing to do. He was probably referring to the possibility of a wink or a nod to certain family members, or perhaps even to a friendly VC that sends you deal flow.

Once again, I'm getting downvoted for illustrating how the vast majority of insider trading goes on unprosecuted. I'm not alleging it in this case, I'm merely pointing out that it's possible.

I'm pretty sure a bunch of the folks you can read about at http://www.sec.gov/spotlight/insidertrading.shtml thought that their winks and nods would go unnoticed.

The vast majority of insider trading goes unprosecuted.

Pointing out that some winks and nods get caught does not mean that most of them get caught.

I'm not sure what your point is. I never made a statement about the percentage of insider trading that was identified, nor did I suggest that most people engaged in insider trading were caught. I merely pointed out the logically obvious: a lot of the people caught engaging in insider trading probably didn't believe they'd be caught.

The point of confluence's recent comments it to highlight the obvious (or I thought it already was) fact that if it can happen, it will happen. Laws of men are not laws of physics, they don't apply unconditionally and immediately.

Also looking through that list I see some really poorly executed insider trading. Going massively long options on shared brokerage accounts:

> the two equally split the illicit profits in their shared brokerage accounts.

-- http://www.sec.gov/News/PressRelease/Detail/PressRelease/137...

I mean come on! If you're going to do something illegal do it with some god damn panache; multiple separate accounts, multiple people, smaller orders, stock only, no paper trails, cash transfers, etc.

> As appraisers we cannot own equity or any economic rights in the companies we value.

Can you sell the data?

Yes, because who wouldn't want to use the services of an appraiser who is going to sell your company's most sensitive financial information to third parties?

I for one refuse to work with an accountant who refuses to sell my tax returns on Scribd.

Sarcasm doesn't really work well on HN.

The issue is someone could conceivably sell the information without your knowledge, or create aggregated data products from that information which aren't so clearly "your information", like "this is where you are compared to your industry as a whole, based on deals we've seen" (which is probably ok).

Because of this, there needs to either be a regulatory control to prevent it, or serious effort from the valuator to convince customers their data is being handled safely.

> Sarcasm doesn't really work well on HN.

So I shouldn't use sarcasm because some people don't care for it?

> Because of this, there needs to either be a regulatory control to prevent it...

Do you know if appraisers are considered fiduciaries? Do you know if any of the societies appraisers commonly belong to have codes of ethics that would prevent the use of client data in any of the ways you describe? I don't, but I suspect that if you were really interested, you could find out in 10 minutes using Google. That would seem to make a lot more sense than screaming "Regulation!" before you knew what appraisers can and can't do currently.

That notwithstanding, I'm always amazed at how quickly folks overlook the importance of trust and reputation in professional service businesses. Do you realize how fast an appraiser would destroy its business if its clients learned that it was using their most sensitive financial information in an unauthorized way?

I am sure this is correct, but you are certainly sitting on a data gold mine.

This is like saying someone who lots of insider information about a particular company is "sitting on a gold mine". Insider trading laws exist for a reason.

I was trying to suggest that the data they are collecting is rather valuable. They don't have to exploit the data (I believe them when they say they won't), but if it were to "escape" then someone could certainly make use of it.

This, and because of this "goldmine" they will become a target for blackhats who will try to get their data. There are people who would pay in megadollars for that data (or even aggregate reports), so there's an incentive, and there's a market.

Exactly. I think that the possibility that highly valuable data might escape is not given enough consideration by both vendors and customers.

Exactly right. Sort of like BitCoin exchanges with hundreds or thousands of coins in a 'hot wallet'. It cannot help but attract those who would do anything for a few bucks.

I'm pretty sure it would be illegal for 4aaS firms to use the data they get through this service to front run the market.

> I'm pretty sure it would be illegal

Doesn't mean they won't do it. I don't know why I'm being downvoted here. It's a statement of fact. You see the same thing happening with investment banks, with the buy side front running sell side clients across that oh so opaque Chinese wall every so often.

This stuff happens. I'm not saying it will happen in this case, but it is a reasonable possibility.

How exactly world you pitch that in your business plan? Under the 'Illegal but potentially lucrative' category? :) Might add well throw in some drug running on the side as well.

Under the "every one of you knows what we're doing, we know that you really, realy need us, so let's not talk about this out loud, shall we?" category ;).

What you have just described would most likely be considered insider trading.

No, that is wrong.

The qualification for insider trading is that it be a public company. Private companies don't fall under insider trading laws and public companies don't do 409a's.

Actually, you're wrong. There are a variety of "insider trading" laws and some apply to private companies too.[1]

[1] http://www.lexology.com/library/detail.aspx?g=e24dc4ab-2a77-...

That case refers to a company defrauding its own shareholders by withholding material information from them during a buyback.

That's far different from what OP is suggesting -- a wink/nod to a third party indicating to buy or sell.

No, that's precisely what insider trading is--trading by any person based on inside information they have acquired through means covered by a fiduciary obligation (i.e. employment, service provider, etc.).

A company can trade on inside information with its own shareholders, since the company is using information it has access to which its own shareholders may not.

Exactly. It's not "trading by any person". Insider trading is can only be done by someone with a fiduciary responsibility.

If a non-involved person somehow acquires "inside" information (without getting it from one with a fiduciary responsibility) it's not insider trading even if the information is non-public.

No, insider trading is not limited to public companies. Indeed, it's more of an issue with private companies precisely because the danger of unbalanced information is so high.

You should read up on the insider trading case law--a good number of the cases involve companies which are not traded on a stock exchange.

Assuming that the SEC regs only apply to public companies is a common misunderstanding. These regs actually apply to all companies which solicit investment, unless a specific exemption applies (i.e., solely intra-state, limited placement private offering, etc.)

Thanks for the info! Any particularly interesting cases I should look at?

The aggregate data would still be useful. It is very common for firms that provide services to lots of start ups to publish "state of the market" type reports.

With the 2048-as-a-service thing earlier, I thought at first that this was just a misspelled attempt to try to one-up them.

Ironically meta, considering how Threes was accused of being a clone of 2048.

I wanted to make a similar comment, thumbs up.


There are many legal/legalistic-type assurance and regulatory frameworks that can be automated, in significant part. I work in a compliance-as-a-service startup (HIPAA specifically, to start). It's absurd how much mediocre consultants and lawyers make doing work that is mostly boilerplate.

Any chance you'd be interested to link to your startup in this thread? You've piqued my interest.

Aptible (https://www.aptible.com). I'm Chas - email me at chas@aptible.com if you'd like to chat. Honest advice is always free, if you're looking to work in healthcare and want to get your bearings. That goes for anyone.

Eh, it's similarly absurd how much software developers make from work that is mostly boilerplate.

From the article: "at the early stage, these valuations are generated in an almost entirely automated fashion."

I'm curious, anyone know what the typical formula is?

Take a look at the top voted post on Quora about 409A valuations.


Basically option pricing. Quoting Henry Ward

"There are tons of large and small firms to choose from. Almost all firms valuing early stage companies use the Option Pricing Model (OPM) (Black Scholes or Binomial) valuation method. So if you have a recently priced round, every firm will give you basically the same answer."

Doesn't the IRS need some algorithm to determine the fair market value of your shares? I see two different possible answers to this question:

- The IRS doesn't use such an algorithm. In this case, how can an IRS audit overcome the "there's no evidence we acted incorrectly, the IRS is just picking on us" defense? If there's no objective standard, how can the IRS ever figure out if anyone's valuation's too low?

- The IRS does use such an algorithm. In this case, what's preventing companies that issue the shares from just using the same algorithm the IRS uses?

They do - they basically all use the Black-Scholes Model [0] and just plug in the numbers.

I assume most of the cost of these 409a's is for the backside covering aspect - if the IRS says how did your come up with your pricing you can point them in the direction of someone "serious" and blame them if they typed in the wrong numbers.

[0] http://en.wikipedia.org/wiki/BlackÔÇôScholes_model

Well, they do have an algorithm. That's why this service works.

Unless you were selected at random, no one reads the paperwork you submit until someone thinks you've done something wrong. They're just evidence that will be examined in the future, so it needs to check out.

For one accounting is fiendishly complex but I would also bet that there is some tiny, irreducible step you need a human being to glance at the paperwork and say "it doesn't look like they're trying to scam us".

Thank god. I'm going through this right now, and all it's done is keep us from issue options and getting an advisor on board, for almost a month now. I'll do anything to make sure we never have to deal with that again.

Thank you! This was a horrible tax on startups -- not just the cost, but the cognitive load before every transaction, and sometimes delaying grants or onboarding at (not very well run) companies due to confusion.

Brilliant!! Like how the landing page explains the fees clearly and how it works.

Does anyone here know if there is an equivalent to 409a in Australia?

I can't see the page, says "403 forbidden"

Do you mean the blog post on http://www.siliconhillslawyer.com or the links to https://www.esharesinc.com? Both seem to be working fine for me.

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