409A Valuation for Different Funding Stages
How do startups determine the value of common shares when they grant stock options, which are important for attracting top talent? Using the 409A valuation is the only way to grant tax-free stock options to employees of a privately held company. In spite of the fact that it’s been around for 15 years, the 409A valuation still leaves many people scratching their heads as to how it works. It has changed from an assortment of now-outdated techniques and wide ranges to a set of established, well-defined methodologies and inputs that are better understood.
409A valuation and Funding stages
The 409A valuation is a method used in determining the fair market value of your company’s common stock. The share price of the product you offer to anyone who is given common stock will be determined by this valuation.
Understanding startup funding stages
The vast majority of successful startups have raised money through multiple rounds of outside funding, with the exception of a select few that are able to do so with little or no outside help.
We’ll look at what the different funding stages are, how they work, and how they differ.
- Pre-Seed Funding – Funding for a new company begins at such an early stage that it is rarely counted as part of its total funding. When a company is in its infancy, the founders are said to be in the “start-up stage”. The most common “pre-seed” funders are the founders themselves, as well as close friends, supporters, and family.
- Seed Funding – The first stage of equity investment is known as seed funding. It typically represents the first official money that a business venture or enterprise raises. A startup’s first steps, such as market research and product development, are made possible with the help of seed funding. A company’s final products and target market can be determined with the help of seed funding.
- Series A Funding – Series A funding can be an option for a company that has established a track record and is looking to expand its user base and product offerings. Investors in Series A funding are looking for more than just great concepts. Instead, they’re on the lookout for businesses that have great concepts but also a solid plan for turning those concepts into a thriving, profitable enterprise.
- Series B Funding – Series B rounds are all about scaling up businesses beyond the startup stage. Investors aid startups by broadening their customer base. The company will use the Series B funding to expand in order to meet this level of demand. Other venture capital firms that specialize in later-stage investing have joined Series B, which makes it different.
- Series C Funding – Those who make it to Series C funding sessions are already doing well. These businesses are always on the lookout for new sources of funding to aid in the development of new products, the expansion into new markets, or even the acquisition of other businesses. The goal of a Series C round is to double an investor’s capital.
Why do startups need seed/series funding?
Seed funding helps a business get off the ground before revenue is generated. It’s a good option for new businesses and those in growth mode because it offers much-needed financial assistance upfront.
It can cover infrastructure, marketing, development, and even initial hiring costs. Any business needs investment, and seed funding is the first drop. Failing due to a lack of necessary working capital or cash reserves is one of the most common reasons for startups to fail.
Other reasons why seed funding is critical include:
- Make up for a lack of resources.
- Minimizes entrepreneur risk
- Involves strategic partners in decision-making
- Working capital availability
- Scaling up and accelerating growth
How can founders get funding for their startups?
Every business needs valuation since it determines how much stock an entrepreneur must provide an investor in exchange for cash. In exchange for a seed investment, a firm with a higher valuation must give fewer equity or shares to an investor. Startup valuation is important for both entrepreneurs and investors since it helps them estimate the return on their investment.
Factors that influence the valuation of a company at seed stages
After seeing how a faulty value may make or break a sale, the next natural issue is determining startup valuation. But first, let’s look at the aspects that affect a company’s valuation:
- Market reputation – Before moving through with the valuation round, founders must ensure a positive market image. An investor’s first consideration is the founder’s image and skill.
- Traction of a company – This is one of the key tenets affecting seed-stage valuation. Traction is the quantitative proof that a startup is getting momentum. Traction is the most crucial factor motivating investors to invest in a firm.
- Business idea or prototype – The creation of a prototype is a crucial factor that might impact the choice of an investor. Always have a working prototype on hand before going in to pitch to investors.
- Revenue – Without question, revenues are critical for any business because they simplify the valuation process for investors. So, if a product has already hit the market and is generating revenue, it may sway an investor’s choice in favor of that firm and serve as a closer deal.
- Distribution channel – It is extremely likely that perhaps the product/service will still be in the early phases of any startup. As a result, founders must be wary of the distribution channel they choose, as it can directly impact the company’s valuation.
- Market size and industry – If the startup belongs to a thriving industry, it is quite likely that investors will pay a premium. This means that it is crucial to choose the proper sector as it will boost the worth of a commercial business.
When organizations enter a new market or create a market through a creative company concept, founders have two responsibilities ahead of them. First, persuade investors, then persuade customers that their business concept is brilliant.
409A valuations for Seed Companies
Startup Company Valuation is the process of determining the startup’s value. Important for startups and entrepreneurs, the valuation process determines how much equity they must provide an investor in exchange for financing.
It also depends on an investor’s willingness to pay a premium to enter a deal. Sometimes, an entrepreneur seeking funding is so desperate that they undervalue their company to obtain funds. Founders want a high valuation, whereas investors want a low valuation with a great ROI. Below are 409A valuations for different funding stages.
409A valuations for Series A
Early-stage companies have a 12-month safe harbor to grant options at the 409A strike price. The exception is when those companies achieve a value inflection point, such as new funding, necessitating a new valuation.
Series A funding requires a valuation of a startup. Unlike seed-stage enterprises, companies seeking series A money can disclose more information to help investors make informed selections.
The valuation method also shows how well a company and its management employ resources to generate future profits.
409A valuations for Series B
A normal valuation for a business seeking financing could be from $30m to $60m. Owners must show that their strategic planning can generate revenue and become a market leaders.
Later-stage organizations should include their auditors and legal counsel in the discussion to determine an acceptable frequency of valuation. This is typically linked to a desire to leave. When a company is considering an IPO in the next 12-18 months, the cadence often increases to quarterly.
409A valuations for Series C
Corporations seeking funding should have a 409A valuation between $100 and $120 million. Founders must show that their business strategy can generate revenue and become a market leader.
409A valuation and VC valuation for a startup
Compliance professionals conduct 409A values that are point estimates at the bottom end of a defensible valuation range. VC values are the market value agreed upon by entrepreneurs and venture capitalists (VCs).
What is a 409A valuation and why is it required?
As said earlier, the 409A valuation is a method used in determining the fair market value of your company’s common stock. A 409A value is mandated by law. A 409A valuation is required to be in compliance. Non-compliance can be disastrous. The IRS can penalize you for undervaluing stock options.
What is VC valuation and why is it required?
Venture capital valuation is a business valuation is a method of valuation by which venture capitalists and investors evaluate a startup. This method usually depends on the view of the investor because they would want a high exit or a good reward for their risk.
It is required for start-ups to process a VC valuation because no venture capitalist would invest without the valuation. Startups would definitely require funding to launch or even grow.
How does VC valuation differ from 409A valuation?
A 409A valuation is typically lower than a VC valuation. The VC values also won’t stand up to IRS inspection. A market-driven valuation is fantastic, but it has numerous flaws. VCs value based on gut instinct. The VC technique also implies that all firm shares are worth the same.
However, 409A valuations are quite distinct. They provide an IRS-acceptable valuation. But keep in mind that these are often low valuations. In general, a 409A valuation has no impact on a VC valuation.
Methods for 409A valuation
The market approach, the income approach, and the asset approach are all approved 409A valuation methodologies. As organizations mature, valuation providers may utilize a combination of these three methodologies:
- Market approach – The market strategy is utilized for early-stage or unprofitable enterprises where long-term financial performance is uncertain. The market method is also known as the option pricing method backsolve. Because new investors pay fair market value for their shares, investors acquire preferred stock. The market technique compensates for common stock value.
- Income approach – A company with adequate revenue and positive cash flow is a good candidate for the income method. This method calculates the company’s fair market value by adding up all assets and subtracting all liabilities.
- Asset approach – Valuers frequently utilize the asset strategy for startups that don’t produce income or haven’t raised funds. This method uses the net asset value to appraise the property.
FAQs about 409A valuation during different funding stages
Before getting started with a 409A valuation, there is important information to take note of. We have gathered the following frequently asked questions and answered them for your benefit:
What are the different stages of startup fundraising?
For a startup, the lifecycle of fundraising can be split into various stages depending on the financial requirements, the maturity of the business, and other aspects such as launching the product or service, reaching the target market and more. Typical stages that a startup goes through are as follows:
- Pre-Seed Funding – The first and the initial funding for developing the idea.
- Seed Funding – Turning an idea into an actual business.
- Series A Funding – Expanding the user base by reaching the target market
- Series B Funding – Scaling the business and its operations to the next level.
- Series C Funding – Developing new products and expanding to new markets.
How does venture capital valuation differ from 409A valuation?
As a matter of fact, 409A valuations are performed by experts and analysts that are estimated at the low end of a defensible valuation. While venture capital valuations are the market value that is attributed entirely to a company.
In addition to this, VCs may not consider 409A valuation as a factor of calculation or input for their valuation; on the other hand, at the time of determining 409A valuation, experts always consider the venture capital valuation.
What happens if the 409A valuation goes down?
It is part of the standard procedure for a company to conduct an annual review of its 409A valuation. However, if the 409A valuation goes down, it might be a sign of trouble. For current employees, they can pay less to exercise their options, while for new recruits, a lower 409A valuation means a lower base price for equity.
As a result, 409A valuation determines the tier of the option grants, which in turn affects the fair market value of equity at an early stage. Therefore, it is important to understand the importance of 409A valuation and how it determines whether the equity is fairly priced.
Need experts’ help for a high-quality 409A valuation for your company?
In conclusion, it is important to remember that If you don’t use one of the allowed techniques, you may not be within the 409A safe harbor. Penalties for employees and stockholders might be significant. For expert advice, Eqvista is here to offer professional services for your business needs. Our mission is to provide your business with advice and help to grow and manage business activities professionally. Contact us to learn more.