409a Valuation for Pre-Revenue Startups
In this article, we explain what a 409A valuation is, how it is done and how pre-revenue startups benefit from the valuation.
In order to find the value of a company’s stock, a 409A valuation is conducted. Usually, established companies have a 409A valuation done when there are major changes to the company. But how do pre-revenue startups get a 409A valuation done? In this article, we explain what a 409A valuation is, how it is done and how pre-revenue startups benefit from the valuation.
409a valuation and pre-revenue startups
A 409A valuation is a formal report that tells you how much your common stock is worth. When you give your employees stock options, you are providing them the opportunity to purchase equity in your company at a price (the “strike price”) that is set today. The primary goal of a 409A is to determine the strike price of your option grants and warrants. Pre-revenue startups are valued in the same way as seed fundraising rounds are, with investors investing monies in exchange for a stake in the company (equity). The investor will calculate the percentage of stock they will receive for the monies invested by valuing the company. It’s never easy to value a company.
Understand pre-revenue startups
Pre-revenue startups are just that; the company has just started out and it is not yet generating any revenue. It takes time to start a business. You must set everything up, plan ahead, possibly hire people, and create the product. Pre-revenue startups are also those startups that are at the early stage of building their business and making sales out of it.
Stages of pre-revenue startups
The pre-revenue startup has different stages on which they are categorized into the following :
- Idea stage – The first step of a company is to come up with a simple product that has the bare minimum of features to meet a need from users or clients. A minimum viable product (MVP) is another name for this product (MVP). At this level, the most basic risk is not turning a concept or hypothesis into an MVP that users actually want.
- Minimum viable products – A minimal viable product (MVP) is a version of a product that has only enough features for early consumers to use and provide input for future product development. Developers can potentially save lengthy and (ultimately) unneeded work if they focus on releasing an MVP.
- Traction – The initial success and momentum that a startup gains as it expands is referred to as business traction. An online firm, for example, can track traction using measures like daily active users, monthly signups, and active users, as well as a lower churn rate.
- Start monitoring – When investors put their money into a startup, they expect to be able to see what’s going on inside the company. Entrepreneurs and investors must establish monitoring efforts to determine whether a business is growing successfully or requires assistance or corrective action.
- Growth – A startup is a business that aims to grow quickly. A company does not become a startup just because it was created recently. It’s also not necessary for a startup to focus on technology, receive venture capital, or have an exit strategy. Growth is the only thing that matters. Everything else we associate with startups stems from their ability to grow. It’s critical to realize this if you want to create one. Each startup must reach a point where it can raise funds from the investor.
Introduction to 409a valuation
A 409A is an independent appraisal of a private company’s common stock or equity reserved for founders and employees’ fair market value (FMV). By getting a 409A valuation done, your employees’ equity-based remuneration (such as stock options, restricted shares, and other share-based equity instruments) can be paid at fair market value.
Safe harbor 409a valuation
Private corporations are given a structure to follow when valuing private shares using a 409A valuation. Getting the valuation done by an independent firm or analyst, it creates a safe harbor 409A valuation. Getting a safe harbor status will let the IRS assume that the 409A valuation done is “fair”.
When do pre-revenue startups need a 409a valuation?
The primary goal of a 409A is to determine the strike price of your option grants and warrants. 409A values are a thorn in the side of every founder. They’re pricey (albeit getting cheaper), and because they’re attempting to value a pre-revenue startup in a disruptive market, they might feel a little like black magic.
- Before issuing common stock – Employees have historically been rewarded with stock options as a means for firms to retain talent. However, issuing them comes with its own set of regulations. Unlike common stock, preferred stock is precisely what it says on the tin. In certain cases, its owners are given preferential treatment over other investors. What that implies in practice is debatable, and it will be spelled out in the fine print of your term sheet. It can cover a wide range of unique privileges. The liquidation preference is the most common and significant. It’s critical to have a realistic assessment of a company’s worth.
- Preparing for funding rounds – Regardless of the nature or size of its activities, every company requires funding to turn its unique ideas into reality. The majority of firms fail because they are unable to raise adequate financing. After all, you’ll need money or capital to keep your company running at all times. If you’re new to the startup business and have no idea how to raise money, you need first familiarize yourself with the various stages.
- IPO and M&A – M&A is aided by IPOs not just by providing financial infusions, but also by giving continued access to stock and debt markets for cash-financed transactions. Furthermore, when the shares are attractively priced, IPOs offer an acquisition currency that can be useful in stock-financed purchases.
- When offering equity – The value of a firm before it goes public or obtains additional investments such as external finance or financing is referred to as a pre-money valuation. A public selling of a company’s shares for the aim of raising finance is known as an equity offering. While offering equity to the business owners it is considered that they must be clear about the policies and process.
Important factors needed for pre-revenue 409a valuation
Pre-revenue valuation is likely to be heavily reliant on estimates. If you determine the value yourself without consulting an independent appraiser or a financial expert, you will have the burden of proving that your assessment was reasonable at the time if the IRS challenges you later. Certain essential factors needed for pre-revenue 409a valuation are as follows:
- Financial statement (profit margin, cash flow, etc) – The process of reviewing a company’s financial statements for decision-making purposes is known as financial statement analysis. External stakeholders use it to assess an organization’s general health as well as its financial performance and business worth. Internal stakeholders utilize it as a financial management monitoring tool. Internal and external stakeholders employ financial statement analysis to assess business performance and value. All businesses must prepare a balance sheet, income statement, and cash flow statement, which serve as the foundation for financial statement analysis.
- Market size – The number of prospective buyers for your product or service is referred to as market size. In business circles, TAM refers to the number of clients or the amount of money you could make if you were 100 percent successful and sold to every possible customer. Understanding the problem you solve for clients and the potential value your solution provides for them is the starting point for determining market size. This is an area that many startup owners in the innovation sector ignore since they are too focused on the product they’ve created to consider how it will assist their target audience. You may have to prioritize which client concerns to fix first, depending on your technology.
- Customer acquisition – The process of attracting new clients is known as customer acquisition. Customer acquisition is used by brands to determine the value of each paying customer by calculating the amount of money spent to bring in a new customer. The bigger the profit, the lower the marketing spend required to gain a new customer. To attract new customers, customer acquisition management can be thought of as a link between advertising and customer relationship management.
- Traction – The initial success and momentum that a startup gains as it expands are referred to as business traction. An online firm, for example, can track traction using measures like daily active users, monthly signups, and active users, as well as a lower churn rate. Traction is proof that you’re making real progress and progress. Traction is evidence that your concept and business idea are viable. It’s not just about proof and evidence for investors and partners, or your team and co-founders, in the early days; it’s also about you.
409a valuation methods for pre-revenue startups
When conducting 409A valuations, analysts commonly use 3 methods to analyze the value of your pre-revenue startup’s stock: asset approach, market approach, and the income approach. These methods are important in valuations.
- Asset approach – In using the asset approach, your company’s net value is the basis of the valuation. The net asset value is obtained by subtracting the total liabilities from the total assets. It can be confusing on which assets and liabilities to include in the assessment and how to measure their worth, which is why it is important to consult with valuation analysts to figure out which is the best for your company.
- Market approach – When an asset is calculated based on the selling price of similar assets, this is called the market approach in valuation methods. The market approach requires a lot of data on similar transactions in order to conduct the valuation. Alternative procedures are conducted if data is not available.
- Income approach – Income approach uses the income generated by the company to determine the fair value. This approach remains as one of the best valuation methods to use. The income approach analyzes a company’s financial history to forecast future earnings.
Penalties if pre-revenue startups don’t maintain safe harbor 409a valuation
Penalties can be costly for pre-revenue startups if they are imposed. The following are examples of penalties:
- All deferred remuneration from the current and previous years is instantly taxable.
- Interest that has accrued on the amended taxable amount
- A 20% surtax on all deferred compensation is imposed.
The IRS is unlikely to audit the majority of startups. However, when your business grows and you approach an exit (such as a merger, acquisition, or IPO), you may face IRS audits. Working with a competent valuation company from the start will save you time and effort.
Why do you need experts’ help for your pre-revenue 409a valuation?
The 409A valuation is the sole mechanism that a privately owned corporation can utilize to offer tax-free options to its employees. 409A less risky valuation approach that qualifies for safe harbor protection. The IRS will usually trust your valuation as a result, and you will avoid any future tax penalties.
Furthermore, you will not be responsible for showing to the IRS that your valuation is correct. However, for this procedure, you will need to choose a skilled and experienced organization that can provide you with the greatest and most appropriate service. In comparison to the other 409A valuation providers on the market, the firm with the appropriate education and expertise would be the ideal pick.
Why choose Eqvista for your pre-revenue startups’ 409a valuation
Pre-revenue startups are valued in the same way as seed fundraising rounds are, with investors investing monies in exchange for a stake in the company (equity). The investor will calculate the percentage of stock they will receive for the monies invested by valuing the company. It’s never easy to value a company. Although a 409a valuation is quite tough, we made it easier for you. Eqvista provides a 409a valuation report that is customized to your company’s needs. To learn more about our 409A valuation services and other business valuations, contact us today.