July 2, 2015 | 4-minute read (736 words)
Valuation is one of those ubiquitous words: at least when it comes to discussions around startups — and, of course, stock market multiples. But it can be confusing because there is not just one type.
In fact, there are several types of valuations and they come into play at different times in a company’s lifecycle. For example, there are the private company valuation figures that get bandied about: think the numbers people reference for Uber and AirBnB for example. And there are public market valuations for where stocks trade now and predictions for what they’ll be worth in the future.
And then there are 409A valuations.
Below I’ll walk through the key differences between business valuations and startup valuations.
1. Business valuations = the price of the company.
They are calculated based on:
- Cash flows (current and projected)
- The value of physical and intangible assets
- The existence of readily identifiable potential strategic buyers
- Market sentiment
2. Startup valuations = what someone is willing to pay.
They are dependent on:
- The size of the opportunity — as measured by the market growth rate
- The team — members’ domain expertise, track record, reputation, and history of prior success
- Traction — this might be measured in users, revenues, downloads, or by some other yardstick
- Your capital needs — how much you plan to spend, on what assets, for what expected impact
- Option pool — the key determinant here is size. The larger the option pool the lower your valuation
- Preferred stock participation preference
- How hot the space is at any given moment aka market sentiment
- Comparables based on recent financings/exits
3. 409A valuations = the value of the business’ common stock (utilized for issuing stock options).
A little background: 409A valuations are named for the section of Internal Revenue Code Section that created them in 2007. The government’s goal was to ensure that federal income taxes are paid on stock issued as a part of deferred compensation plans.
What impacts a company’s 409A valuation:
Do you see the overlap with the factors that come into play for equity valuations?
- Company milestones
- The industry’s competitive dynamics
- Strategic partnerships
- Your investor base
- The quality of your management team
409a valuations do have some other wrinkles though.
409a valuation: determining factors
409a valuations and companies benefit from a “safe harbor” provision that a valuation “reflects the fair market value (FMV) of the stock…” And that they should be deemed valid if “the valuation is based upon an independent appraisal, … by a qualified individual or individuals…”
In determining FMV, The IRS deems “...relevant factors prescribed for valuations...” including:
fair market value (FMV) — “determined by the reasonable application of a reasonable valuation method.” Clear as mud, huh?
“...evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.”
Recent equity sales i.e., comparables
The IRS also stipulates that valuations be performed by “a qualified individual” with “significant knowledge and experience or training in performing similar valuations.” What counts as significant? For the IRS, it means “at least five years of relevant experience.”
409a valuation audit
Oh, and one other thing; if you plan on selling your business or raising capital, most potential investors and all savvy acquirers will request an audit. One of the items they’ll be scrutinizing is your 409a valuation.
If all this raises more questions than it answers, you are in good company. Clearly 409a valuations impose high standards — and the average founder is unlikely to be equipped to meet them.
Whether it’s your first 409a valuation or your annual update, hiring a qualified professional who can guide you through the process, explain the nuances, and will guarantee its product, is your best bet.
Do you have more questions on valuation or need assistance in determining your 409a valuation? Ask us in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS