IRS Regulation 409A really sucks. While I’m probably now on some audit watch list as a result of speaking my mind, there really isn’t any other way to state it. Jason Mendelson and I were bitching about this today as we pondered how to deal with it and decided that we might as well try to constructively air our thoughts (and help educate our entrepreneurial and venture brethern on some of the issues) via a 409A Series (similar to our Term Sheet and Letter of Intent series). Remember – we aren’t lawyers (ok – Jason is…) and this isn’t legal advice – just the thoughts and opinions of two guys dealing with this stuff everyday. 

In case you missed it, proposed IRS Regulation 409A, dealing with deferred compensation, is making everyone in the startup community run around like chickens with their heads cut off. It’s a broad regulation, but in a nutshell, for private companies it redefines the way companies determine fair market value in granting stock options. In the “old days” (before I was 40 years old) the board would spend time and make a good faith determination what the fair market value was and grant options. Now, companies must formally value their common stock options (by one of two prescribed methods that we’ll get to later) or risk the penalties should they be wrong with their option pricing. Please note that this regulation also affects public companies, venture capitalists, severance contracts, any sort of deferred compensation, etc., but we’re only going to focus on the private company option pricing nightmare.

Because everyone likes the punch line, the simple answer to “what are the penalties?” is this: The penalty for undervaluing options is that the option holder gets taxed at normal income rates on the “spread” (difference between the grant strike price and what the IRS deems the “correct” value) as if it was income given to him by the company PLUS an additional 20% tax on top of this in further penalties. Furthermore, the company gets penalized on withholdings it should have made on this additional “income” it provided to the employee. 

But wait, it gets better. Did we mention that these are only proposed regs, but the IRS says everyone must comply with them immediately as if they will be adopted and oh yeah…. they’re retroactive also and any stock option that still has vesting left as of January 1, 2005 is subject to the regs. Yes, if you granted or received an option in mid-2001 with typical 4 year vesting, congratulations, you are subject to 409A.

Basically, everyone involved gets fucked. 

Interested? Scared? Reconsidering a new career as a 409A valuation expert? In this series we’ll take your through some detail on the joys of 409A. If you are a masochist and want some good reading, Cooley Godward has a good overview online as does O’Melveny & Myers.

In the mean time, sleep well.  While we wish we could spray some Formula 409 on this and make it go away, we know the value of facing reality and will provide some addition information in our next post.

For my 40th birthday, I got a couple of cool t-shirts with photos of me substituted for Jack Bauer on 24.  The only thing disconcerting was the image of me holding a handgun.  I was pondering how ripped I looked (on Jack’s torso) when two questions on term sheets came in from someone at Ernst & Young.  Being the excellent delegator that I am (much better than Jack, if you know what I mean), I forwarded the questions on to Jason who promptly answered them.  They are as follows:

1. What would you deem the most hotly contested points of the term sheet? The most hotly negotiated term (after price) is the liquidation preference. In a Series A deal, it is between the company and the investor. While it’s often an intense negotiation, it’s straightforward because there are only two interests to consider (the founders and the Series A investors). In later stage, the negotiations become even more interesting. Take a situation where you have a Series D deal with each Series (A, B, and C) having different prices. By definition each of the different Series investors will have different payouts on their previously purchased stock and the Series D investors will be negotiating with several sets of interested parties (the founders, the Series A investors, the Series B investors that are not in the Series A, and the Series C investors that are not in the Series A / B).  Of course, the notion of participating preferred plays into this negotiation also.

2. In your view, how has the role of legal counsel changed over time during the deal process (in the past 10 years or so)? Legal counsel is relied on more heavily these days to be a business arbiter, rather than a “take no prisoner negotiator” who must win every last deal point. These deals aren’t rocket science and any good lawyer knows that.  As a result, legal counsel (at least good legal counsel) is now much more of a deal maker than hard ass negotiator.

My friend Larry Nelson who runs w3w3.com just put up a short interview he did with me last week.  Per Larry’s description:

Here’s some candid straight talk about access to VC capital in Colorado. Brad Feld, Managing Director of Mobius Venture Capital didn’t have much good news to talk about when w3w3.com interviewed him two and three years ago. Brad gives some specific examples and offers some interesting advice for the coming year. For some, it is going to be a very good year and others will struggle. Brad points out that mid-stage and later-stage activity is very healthy.

The Denver Business Journal has a nice article about my friend Niel Robertson, co-founder / CTO of Newmerix.  Neil joined the ranks of CTO bloggers a few weeks ago.  For the record, I like his earring.

The Denver Post had a nice profile article on a couple of local Boulder / Denver CEO’s that run, including me (ok – I’m a “managing director” – but who really cares about titles).  Ed Roberto – the CEO of Newmerix and occasional running partner was featured also.

I’ve received a variety of entertaining (and thoughtful) presents for my 40th birthday.  Earlier this week, Dave Jilk gave me another one – my own Wikipedia entry.  I suppose every kid wants an entry about him in the dictionary – my ego is highly entertained.  Thanks Dave.

Now – that’s a mission statement.  I’m on the board of the Colorado Conservation Trust and we had a board meeting last week.  CCT is one of the best organized non-profits I’ve ever had the privilege to be involved with and is unambiguous about its goal.  The mission statement says it all – “Conserve 2,000,000 Acres in the Next Decade – Let’s Get Going.” 

I’ve lived in Colorado for 10 years.  Part of the magic of this place is the mountains, the open space, and the wide stretches of undeveloped land.  Boulder benefits greatly from the city and county’s forward thinking conservation attitude from many years ago, resulting in a magnificent city in an environmentally protected setting.  None of this was by accident and I’ve tried to do my part in the last decade to help locally.

CCT broadens this view across the entire state.  There are numerous environmental organizations in Colorado – some effective, some not.  There is the typical conflict you’d expect from an area that is undergoing huge growth ranging from private property rights to zoning issues to wildlife protection.  In addition to actively participating in conservation, CCT has taken a leadership role in understanding what is going on in conservation across the state.  Recently, they released Colorado Conservation at a Crossroad – their first comprehensive report on conservation in Colorado

Since it was founded in 2000, CCT has contributed to the protection of more than 30,000 acres in Colorado.  It’s raised $10 million from 30 foundations in and over 300 individuals.  It’s leveraged the $10 million with an additional $24 million of public and private dollars.  It does this with a staff and organization that is 100% underwritten by its board of directors – we cover 100% of CCT’s operating costs so that all of the money that is contributed can be directly deployed against land conservation programs.

If you live in or enjoy Colorado, you should be happy there are folks like Will Shafroth and his team at CCT working hard to help keep it special.  We’re always looking for additional support of any kind and – as the end of the year rolls around and you consider any philanthropic giving – I’d encourage you to consider a gift CCT if you are conservation minded and enjoy Colorado.  Remember – 100% of your money will go to land conservation – we (the board) has got the admin stuff covered.  If you want to learn more or get involved, feel free to contact me.

I monitor around 400 blogs and try to stay on top of them daily (I use FeedDemon and NewsGator Online and have developed an awesome personal algorithm for getting through all the items quickly.) I also use a handful of services such as Tech Memeorandum to follow what people are talking about. I’m a fast reader and excellent skimmer so that helps.

I had a very busy day yesterday that started early so I didn’t read anything from Thursday evening through Saturday morning.  I just finished going through everything and was stunned by the amount of discussion about the Yahoo / del.icio.us deal.  I’m very excited and happy for everyone involved, but as I read through post after post after post saying “Yahoo bought del.ciou.us” I started to feel something was wrong.  I checked on Technorati – “delicious” is the number one search this hour (and Yahoo is four; Delicious Yahoo is six).  I checked NewsGator’s Latest Buzz – the first is Joshua’s post and the second is Jeremy Zawodny / Yahoo’s post.

Forget about the TAR stuff (trust / attention / relevance) for a second – there is a huge content imbalance when everyone is writing about the same thing.  There was a very large and interesting deal done on Monday last week that arguably has much greater importance to the structure of the tech / media business than Yahoo / del.icio.us and it had extremely little coverage by the tech bloggers.  Can you name that deal?

Liberty Media acquired Provide Commerce for $477 million (PRVD was public – $33.30 / share – 50% valuation increase in the past 60 days).  Now, maybe I’m more sensitized to PRVD and L since they are both Colorado related company (L is headquartered here, PRVD is headquarter in San Diego, but the founder and good friend Jared Polis is based in Boulder.)  This is Jared’s second monster win – his first was the sale of BlueMountainArts.com to Excite in 1999 for around $800 million.  Oh – and he had other successes like the sale of AIS to Exodus in 1995.

But – no one is talking about this.  More specifically, very few people are speculating on what Liberty Media is up to.  John Malone and Liberty are clearly interested in making yet another round of moves, this time with focus on Internet related properties.  Greg Maffei joined Liberty Media as CEO a few weeks ago and – while Fortune had a decent introductory article setting up the landscape – there’s been very little chatter about what might become another key entrant in GAAMEY (Google / Amazon / AOL / Microsoft / eBay / Yahoo).  Oh – and where is the discussion about InterActiveCorp (IACI) – same drill  – $9 billion market cap company with key online assets and a chairman (Barry Diller) who happily and regularly makes big strategic moves.  Should GAAMEY become GAAMEYIL (or maybe AGILEAMY in honor of my wife.)

I’m perplexed.  Fortunately I have a two hour run today to ponder this more.

Anyone that’s walked (or run) across the Harvard (aka Mass Ave) bridge has noticed little numbers painted on it that end at 364.4 (and one ear).  If you are an MIT grad, you know that in 1958 Oliver Smoot and his frat brothers from Lambda Chi Alpha measured the bridge in “Smoots” (Smoot was 5’7” and was the shortest dude in his pledge class), painting the bridge in intervals of Smoots one fall evening.  This tradition of repainting the bridge has lasted since 1958 and I always get a chuckle in the fall when I end up in Boston and go for a run that crosses a bridge when I hit “69” or “halfway to hell”.

Oliver Smoot retired last week.  His day job was as Vice President at the Information Technology Industry Council (DC-based high-tech trade group).  He also served on the board of the American National Standards Institute, the DC-based association that sets standard units and measurement guidelines. 

Ok – pause and think about it – the guy that became the unit of measure for the Harvard Bridge (a Smoot) has been serving on the board of the American National Standards Institute.  I love it.  NPR had a great interview with Oliver Smoot on Pearl Harbor Day – if you’ve ever walked across the Harvard Bridge, you’ll get a good chuckle out of it.

Smoot is now a serious and endearing measurement.  If you ever wondered how long the Harvard Bridge actually is, Google Calculator will happily provide a translation from smoots to yards.  I expect that if you are a math nerd, you’ve known for a long time that the ear is a proxy for epsilon.