409A Valuations in Distress, Restructuring or Wind-Down

Scope of this page: it deals with distress, restructuring and wind-down. The mechanics of the probability-weighted method itself, including how to build a scenario tree, are in our PWERM guide. Down-round pricing, anti-dilution and pay-to-play conversions are in our 409A down round guide. This page links to both rather than repeating them.

What Makes a Company "Distressed" for 409A Purposes

Section 409A has no definition of financial distress. The regulations only require a reasonable valuation method that considers all available information material to value, under Treasury Regulations Section 1.409A-1(b)(5)(iv)(B). Distress matters because it changes that information. In practice, appraisers treat a company as distressed when one or more of these facts is present:

• Short runway. Less than about 12 months of cash at the current burn rate, with no committed financing to extend it.
• A failed or stalled raise. A process that produced no term sheet, or a lead investor who withdrew.
• Debt pressure. A breached covenant on venture debt, a forbearance agreement, or a maturity the company cannot meet.
• Going-concern doubt. Under ASC 205-40, management must evaluate whether there is substantial doubt about the company's ability to continue as a going concern within one year after the financial statements are issued. A going-concern disclosure or audit opinion paragraph is direct evidence for the appraiser.
• Strategic alternatives. A board decision to explore a sale, a merger or a shutdown.

The stage label on the company matters less than the data. A Series B company with eight months of cash and no investor interest is more distressed than a seed company that closed its round last quarter. Revenue, its trend, and how recently the company raised money tell the appraiser more than the name of the last round.

How do you value common stock in a distressed company?

Appraisers usually value common stock in a distressed company by weighting a few explicit outcomes: a financing that keeps the company going, a sale, and a wind-down. Each outcome gets its own equity value and its own allocation through the liquidation preference stack. The probability-weighted result, less a discount for lack of marketability, is the fair market value per share.

That is why the probability-weighted expected return method (PWERM), or a hybrid of PWERM and the option pricing model, is so common in a 409A valuation for a distressed company. A single OPM run on one equity value assumes a smooth range of outcomes. A company on the edge of a shutdown does not have one. Our hybrid method guide explains how the two are combined when the financing scenario still has a wide range of results.

The single most important input is the wind-down probability. It should be derived from the company's facts and written down, not picked to land on a target price. A closed financing in the last 12 months, or a signed term sheet or LOI, is evidence of continued operations and should reduce the wind-down probability. Six months of cash with no investor interest should increase it. An appraiser who cannot explain the probability with reference to the company's runway, revenue and financing history has not supported it.

Going Concern or Liquidation: Choosing the Premise of Value

Every valuation rests on a premise of value. Most 409A reports assume a going concern, meaning the business keeps operating and its value comes from future cash flows or from what investors would pay for it. A distressed company may also need a liquidation premise, meaning value is what remains after the assets are sold and the claims are paid.

The two premises rarely produce close numbers. A software company's going-concern value may sit in its customer relationships, its team and its growth, almost none of which survive a shutdown. Its liquidation value is mostly the cash on hand, collectible receivables and whatever a buyer will pay for the code and domain names. A 409A wind down valuation is therefore often a fraction of the company's last post-money valuation, even before the preference stack is applied.

Appraisers do not usually choose one premise and discard the other. The going-concern premise drives the financing and sale scenarios, and the liquidation premise drives the wind-down scenario. The weighting between them is where the judgment sits. Only when a shutdown has been approved and announced does the liquidation premise take over completely.

Building the Wind-Down Scenario

In a 409A wind down valuation, the wind-down scenario is a cash walk. It starts with what the company would actually realize and subtracts every claim that ranks ahead of common stock:

1. Cash at the expected wind-down date, which is the current balance less the burn until operations stop. Waiting longer means less cash.
2. Realizable value of other assets. Receivables collected at a discount, intellectual property, equipment and any sublease income. Assets sold in a hurry rarely bring book value.
3. Wind-down costs. Severance and accrued payroll, lease terminations, contract exit costs, insurance tail coverage for directors and officers, and legal and accounting fees for the dissolution.
4. Liabilities. Venture debt, trade payables, taxes and any other creditor claims, which are paid before any distribution to stockholders.
5. Preferred liquidation preferences, paid in order of seniority under the charter, including any participation rights.
6. Whatever is left, shared by common stock and any participating or converting preferred.

For most venture-backed companies the walk ends at step five. The preferred stock's liquidation preference is usually at least the amount invested, and a company in distress rarely has that much cash left. So common stock typically receives nothing in the wind-down scenario. That is not an error in the model. It is what the charter says happens.

A distressed sale works the same way, starting from the expected purchase price instead of liquidation proceeds. Acqui-hires are a frequent case. Much of what the buyer pays may go to retention packages for the employees it hires, not to the company's stockholders, so the price available to the waterfall can be far below the headline figure.

Can a 409A valuation of common stock be zero?

Rarely, while the company is still operating. Common stock may receive nothing in the wind-down scenario, but the financing and sale scenarios usually still give it some value. Common also behaves like a call option on the company, which keeps some value whenever recovery is possible. The result is often a low positive value, sometimes only cents per share.

A conclusion of zero or near zero is defensible only when every realistic outcome leaves nothing for common, for example after a board has approved a dissolution or an asset sale for less than the debt. At that point the question is usually moot, because the company should not be granting options at all.

There is also a practical floor. State corporate law generally does not allow shares to be issued for less than their par value, so an option's exercise price is normally set no lower than par even when the 409A value is lower. Par value for startups is usually a small fraction of a cent, so this rarely matters, but check it before the board approves a grant at a very low price.

Restructurings: Recaps, Debt Conversions and Rescue Financing

Many distressed companies do not shut down. They restructure. The transaction that saves the company also changes the capital structure that the 409A has to allocate value across, so the valuation after a restructuring is a new analysis, not an update of the old one.

• Recapitalizations. Existing preferred may be converted to common, reverse-split or replaced with a new senior series. Converting old preferred to common can actually raise the value per common share, because it removes preferences that ranked ahead of common. The appraiser needs the post-closing capitalization table, not the pre-deal one.
• Debt conversions. Venture lenders or noteholders who convert into equity remove a senior claim but usually receive a senior preferred class in return. The appraiser needs the new terms, including any liquidation preference multiple.
• Rescue financing. New money in a distressed round usually comes with senior preferences, multiple liquidation preferences or warrants. The new price per share is important evidence of value, but only after the terms are modeled, because a preferred share with a 2x preference is not worth the same as one with a 1x preference.

The pricing side of a down round, including how anti-dilution adjustments and pay-to-play provisions change the preference stack, is covered in our down round guide. For a backsolve from a rescue round's price, see our backsolve method guide. A financing done under real distress may not be an arm's-length indication of value, so the appraiser should say how much weight the round price gets and why.

Do you need a new 409A valuation when your company is in distress?

Usually, yes, before the next option grant. An independent appraisal is presumed reasonable for up to 12 months, but only if it reflects all information that materially affects value. A failed raise, a covenant breach, going-concern doubt or a decision to explore a sale is that kind of information, and it can make the old report stale.

The regulations say a valuation is not reasonable if it fails to reflect information available after its valuation date that may materially affect value, or if it is more than 12 months old. Our guide to material events for a 409A covers the general rule. In distress, the key point is that bad news triggers it as surely as good news does. A board that keeps granting at an old, higher price is not exposed to 409A penalties, because an exercise price above fair market value does not create deferred compensation. It simply grants options that are already underwater, which helps no one.

Safe harbor risks specific to distress

The real risk runs the other way: a low value that later looks unsupported. If the company recovers quickly after grants at a distressed price, an examiner or auditor will ask whether the distress was real and fully documented. Three points protect the board:

• Use an independent appraisal. Under the 409A safe harbor, the IRS can rebut an independent appraisal only by showing that the valuation method or its application was grossly unreasonable.
• Watch the illiquid-startup method. That safe harbor is unavailable if the company reasonably anticipates a change in control within 90 days or an IPO within 180 days. A distressed sale process can rule it out.
• Do not time grants around known news. If a rescue term sheet is being negotiated, the appraiser must know about it. A grant made at a wind-down-weighted price while a financing is nearly signed is exactly what the "all available information" rule is meant to catch.

If an exercise price turns out to be below fair market value, the penalties fall on the employee: income inclusion as the option vests, an additional 20% federal tax and a premium interest charge, as explained in our 409A penalties guide. Grants at a low price help employees only if the price is well supported.

Option Grants, Repricing and Retention Plans During Distress

A well-supported low 409A value can be useful. New hires and retained employees can receive options at a strike price that leaves real upside if the company recovers. Existing options granted at higher prices will be underwater, and some companies reprice or exchange them. The 409A rules, tax consequences and ASC 718 accounting for that are covered in our guide to repricing underwater stock options. The main point here is that a repricing needs a current fair market value as of the repricing date, and the new exercise price must be at or above it.

Options are a weak retention tool when everyone knows common may receive nothing in a sale. Distressed companies therefore often use two other arrangements, and both raise Section 409A questions of their own:

• Management carve-out plans set aside a percentage of sale proceeds for employees, ahead of the preferred stock, so the team has a reason to stay through a sale. A carve-out is a right to future compensation. Paid at closing, it usually fits the short-term deferral exception. Escrow holdbacks, earnouts and installment payments can push payment later, and then the plan needs fixed payment terms that comply with Section 409A.
• Retention bonuses paid in cash for staying through a set date or a transaction are generally short-term deferrals if they are paid within the period the regulations allow after they vest, which is generally by the 15th day of the third month after the end of the employee's or the company's tax year in which they vest, whichever is later. Bonuses that pay later, or that the company can delay, need closer review.

Draft these before a deal is signed. Fixing a noncompliant carve-out plan after the buyer has already set the payment schedule is much harder.

409A in a Wind-Down: Terminating Deferred Compensation Plans

Once the board approves a dissolution, the valuation question mostly ends: no new options should be granted, and outstanding options typically expire or are cancelled under the plan's terms on a dissolution. A separate Section 409A issue remains if the company has nonqualified deferred compensation, such as deferred bonuses, severance payable in installments, or phantom equity with fixed payment dates.

Section 409A generally prohibits accelerating payments. Treasury Regulations Section 1.409A-3(j)(4)(ix)(A) provides an exception for a corporate dissolution. The company may terminate and liquidate a plan within 12 months of a dissolution taxed under Section 331, or with the approval of a bankruptcy court under 11 U.S.C. 503(b)(1)(A). The deferred amounts are included in income in the latest of three years: the year of the termination and liquidation, the first year the amounts are no longer subject to a substantial risk of forfeiture, or the first year payment is administratively practicable.

This exception matters in practice. Without it, a dissolving company might have to keep a plan alive just to make payments on the original schedule. Counsel should confirm that the dissolution fits the rule and document the termination.

The Bottom Line on a 409A Valuation for a Distressed Company

A 409A valuation for a distressed company comes down to being honest about the outcomes. The appraiser models the financing, the sale and the wind-down the company actually faces. The wind-down probability comes from runway and financing data, not from a target price, and a 409A wind down valuation shows every claim paid ahead of common. Each scenario goes through the real preference stack. The board, for its part, refreshes the valuation when the facts change and documents why. Before the next grant or restructuring:

• Give the appraiser the current runway, burn, pipeline and the status of every financing or sale discussion, including any term sheet or LOI.
• Provide debt agreements, covenant status and any forbearance terms, along with the full charter and preference terms.
• Order a new 409A after a failed raise, a covenant breach, going-concern doubt, a restructuring closing or a decision to explore a sale.
• Pause grants while a sale or rescue financing is being negotiated, unless the appraiser has the terms.
• Have counsel review carve-out plans, retention bonuses and any deferred compensation before a deal or dissolution.

This article is general information about Section 409A valuations for companies in financial distress. It is not legal, tax, accounting or valuation advice. Restructurings, sales, dissolutions and bankruptcy proceedings raise corporate, tax and creditor-rights questions that depend on the facts; consult tax and corporate counsel, your accountants and a qualified valuation professional about your situation.