409A Valuation for Pre-Seed Funded Startup

The 409A valuation is a term used to identify a private company’s common stock’s fair market to facilitate various transactions. Pre-seed funded startups refer to the stage or period in which a startup is merely an idea or an early-stage business with little to no revenue streams. As such, financing a startup often involves many assumptions and amounts of risk; thus, having 409A valuation models is beneficial. In this article, we will discuss the concept of pre-seed funding and 409A valuation for pre-seed funded startups.

Pre-Seed Funded Startups

Before delving into the details of pre-seed funded startups, let us first understand what pre-seed funding is. The initial or earliest funding of a startup is usually done via pre-seed funding. Typically, founders themselves or those involved in the startup process contribute early capital to the pre-seed. However, accelerators, angel capitalists, venture capitalists, or wealthy individuals also provide pre-seed funding. In this regard, pre-seed funded startups tend to be in the early stages of development, often in the idea validation stage.

In order to gain traction and attract investors, startups must have a good business model. In addition to this, they must also be able to demonstrate an ability to deliver returns. Typically, the main priority of pre-seed-funded companies is to attract further funding. In some cases, when these companies reach the growth stage, they may forfeit their equity positions in exchange for more funding. As a result, pre-seed funding is often used to fund early-stage startups with strong potential to develop into profitable ventures.

What is a pre-seed funded startup?

Pre-seed funded startups are early-stage startup companies that receive capital to fund business operations during the idea validation stage. Pre-seed funding is usually provided by friends, family and/or other investors who believe in the product or service of the company. Basically, it is the stage when a company has an idea that they believe is feasible and has the potential to gain significant traction in a short period of time.

Pre-seed funded startups can be in different stages of development. Some are still in the ideation stage, others are in the development stage (working on the initial prototype), and some are at the validation stage (testing their product with users). Although pre-seed funding does not provide a lot of capital to the startup, it does help to get the startup off the ground.

Case Study for Pre-Seed Funded Startup

Zephyr AI is a fast-rising cloud storage startup known for its AI-powered data security solutions.  The founders realized they needed initial capital to build a prototype and conduct research.

They received $150,000 in pre-seed funding from a combination of their savings, contributions from family and friends, and an investment from an angel investor.

With this pre-seed funding, Zephyr AI was able to:

• Refine their minimum viable product (MVP) and conduct initial testing.
• Conduct market research to analyze the needs of the target audience better.
• Hire additional team members with expertise in AI.
• Cover operational costs for the next six months.
• Begin the process of obtaining necessary regulatory approvals.

This initial funding set the stage for Zephyr AI to further develop its product, attract additional investors, and eventually enter the market.

When should a startup raise a pre-seed round?

The initial round of funding is usually raised when a startup has something to show to potential investors. This means having either a tested business model or a product prototype that they can demonstrate to the investors. Here are a few scenarios that you can use to determine when a startup should raise a pre-seed round.

• To increase marketing – Pre-seed funding can be used to increase marketing and improve the strength of your product or service. You can use this as a bridge to get your marketing strategy in place before you go for the next round of funding. As a matter of fact, marketing plays an important role in getting the attention of potential customers, building brand recognition, and generating awareness around your product or service. Using various digital marketing tools such as websites, social media, blogs, videos, and traditional marketing tools like brochures, magazines, direct mailers, and billboards, can help you raise awareness and interest in your startup. Thus, pre-seed funding can help to support your marketing budget and provide you with more resources to expand your customer base.
• To build an excellent team – Beyond the fact that a good team can take your startup from ground zero to the next level, pre-seed funding is also used to source talented individuals who can add value and make a difference in the success of the business. Technical founders, project managers, and engineering employees can be hired to help build the first version of your product or service. Consultants, mentors, and advisors can be chosen to guide you through the various challenges associated with building a startup. All of these individuals can cost a startup a considerable amount of money. However, a pre-seed funding round can be used to hire some of these talents and get their help in building the company.
• To build a prototype – In this case, the pre-seed funding is used to build the first prototypes of your product or service. This helps you understand what works and what does not work. In fact, a good prototype helps you to think more strategically. A prototype is also a tool that can attract the attention of investors, attract future customers and increase your conversion rates. As a result, a prototype can help you establish your business vision and can be used to test, change and improve your approach to building the product or service. Pre-seed funding can help to reduce the initial capital required to build a prototype.
• To prepare revenue modeling – Having a solid business model is a critical element in securing funding for your startup. A business model can help you to determine your startup costs, how much revenue you can generate, and how much profit you can make from the business. Pre-seed funding is used to build a revenue model that demonstrates the financial viability of your idea or product. That being said, a pre-seed funding round can help you prepare a viable revenue model and improve the chances of securing investments.

Challenges in raising pre-seed funding

There are many challenges when you are considering raising pre-seed funding. Some of them include the following:

• Not having enough financial data and backup – Typically, early-stage startups have little or no historical financial data to prove the viability of their business model. The lack of this data makes it difficult for potential investors to determine the level of risk involved and the viability of the business. This is why a good business plan is needed to demonstrate the strengths of the business model and provide potential investors with enough information to consider the investment.
• No records of cash flow – Since startups are still in the early stages of development, they do not have any actual cash flow to show the viability of their business. The absence of cash flow and the use of projections can make it difficult for investors to determine the amount of risk involved. Thus, it is essential for startups to have a good cash flow model or a primary analysis of what the cash flow will look like.
• Not having a product or service – This is another significant challenge in raising pre-seed funding. Even if the startup has an attractive business model, it is difficult for investors to place a value on the company since there is no product or service being developed yet. It is, therefore, important for the startup to present a prototype that shows the potential of the business. This can also help the company qualify for pre-seed funding and improve its chances of securing later-stage investment.
• Not having an expert team – In addition to having a good product or service, it is also essential to have a strong team that has enough experience in building and/or running a startup. Having a team that consists of people with the right skill set can help the startup execute its business model more efficiently. Investors often consider the team’s competency when investing in a startup. Thus, it is important for the startup to present a team that has both passion and the right skills to help build the business.

Eqvista, a leading provider of 409A valuations, can help startups navigate the challenges of raising 409A valuation for pre-seed funded startups. Its independent and defensible 409A valuation provides an objective assessment of the startup’s fair market value. By leveraging Eqvista’s expertise in 409A valuations, pre-seed startups can overcome challenges in raising funding, establish credibility with investors, and position themselves for long-term success.

How to raise pre-seed funding for your startup

• Build a Compelling Pitch Deck – Creating a strong pitch desk is crucial for securing pre-seed funding. Your pitch deck should clearly articulate your business idea, market opportunity, product/service, target customers, competitive landscape, financial projections, and the team’s expertise.
• Conduct Thorough Market Research – Pre-seed investors are eager to see you have a deep knowledge and understanding of your target market. By conducting extensive market research, you not only demonstrate market validation and customer demand, but also build a strong foundation of confidence in your ability to solve a real problem.
• Leverage Your Network – Use your personal and professional networks to find potential pre-seed investors. Friends, family, former colleagues, and industry connections can be valuable funding sources or introductions to angel investors.
• Attend Startup Events and Pitch Competitions – Participate in startup events, pitch competitions, and accelerator programs to increase visibility and connect with potential investors. These platforms provide opportunities to pitch your idea and receive feedback.
• Consider Crowdfunding – Crowdfunding platforms like Kickstarter or Indiegogo can effectively raise pre-seed capital, especially if you have a consumer-facing product. However, ensure your product or idea is compelling enough to attract backers.
• Set a Realistic Valuation – Pre-seed funding often involves giving up equity in your startup. Work with a professional to determine your company’s fair and defensible valuation, considering its stage, market potential, and team experience.
• Demonstrate Traction and Expertise – While you may still need to develop a fully developed product, showcase any early traction, such as customer interest, pre-orders, or pilot projects. Highlight your team’s relevant expertise and passion for the business.

According to one of Eqvista’s valuation experts, “Raising pre-seed funding can be challenging, and you may face numerous rejections. Stay persistent, learn from feedback, and continuously refine your pitch and strategy. Remember, pre-seed investors bet on your idea’s potential and your team’s execution ability”. Eqvista can play a crucial role in helping startups raise pre-seed funding by providing accurate and defensible 409A valuations.

Why a 409A Valuation is Important for Pre-Seed Funded Startups?

A 409A valuation is crucial for pre-seed funded startups for several reasons:

• Determining Fair Market Value of Equity – The primary objective of a 409A Valuation is to determine the FMV of Common stock in a startup. At the time of granting stock options or other equity compensation to employees and founders, this is crucial for early-stage startups. Accurately determining the FMV helps avoid tax penalties from undervalued equity grants.
• Attracting Investors and Talent – Pre-seed startups often use equity compensation to attract investors and top talent. A 409A valuation helps set the strike price for stock options, making them more attractive for potential hires. It also provides investors with an independent assessment of the company’s worth.
• Facilitating Seed Funding – Many investors require a 409A valuation before investing in a pre-seed startup. The valuation indicates the company’s value and helps investors make informed decisions about their investments, instilling a sense of confidence and security.

Example 409A Valuation for Pre-Seed Funded Startups

Consider a pre-seed funded startup called Zephyr AI, which is developing AI-powered data security solutions.

The company then decided to take on its initial investment in the form of pre-seed funding, from investors. The total amount of the funding was $150,000 to support the company to develop its product and expand its market. With this investment, the share price buy-in was $0.25 per share.

To issue stock options to its employees and comply with IRS regulations, Zephyr AI needs a 409A valuation. Here’s how the process typically works:

• Calculates the startup’s assets both tangible and intangible assets:

• Projections and estimates to know what the company will be worth in the future. The factors that could affect the company’s growth over a certain period are considered.
• If no recent transaction exists for the company, the backsolve technique is used to determine the value of the company’s common stock. In this case, the funding round sets the company’s pre-money valuation and the price per share. With this investment, the price per share was $0.25 per share for pre-seed.

• The 409A valuation process, considering the new capital, reduced risk, and progress toward product launch calculates the FMV of common stock.
• The FMV of the common stock is determined to be $0.03 per share.  

Does a pre-seed stage startup require a 409A valuation?

409A valuation is used to determine the fair market value of a private company’s stock. However, there are circumstances where potential investors might consider the FMV of a startup’s stock. Usually, early-stage startups have not generated any revenue; determining the FMV of a startup’s stock can help investors to assess the company more thoroughly. For instance, venture capitalist firms consider the FMV of a startup’s stock when they are evaluating an investment proposal.

This means that there might be situations where potential investors want to use the 409A valuation to determine the value of a startup’s stock. If you are raising pre-seed funding, then it is essential to include a 409A valuation as a part of the pitch deck. Furthermore, in order to issue equity grants for hiring top talents, the FMV of the startup’s stock might be used for determining the value of the equity compensation.

How is the 409A valuation for the Pre-Seed funded startups done?

The 409A valuation process is done by an independent and qualified appraiser. Following are a few methods:

• Calculate the startup’s assets – Since 409A valuation is based on calculations, the appraiser must assess the startup’s assets. The appraiser should consider both tangible and intangible assets. It is essential to be detailed in the description of each asset and include relevant information to substantiate the value.
• Calculate what the company will be worth in future – The projections and estimates of the appraiser will be used to determine what the startup will be worth in the future. Note that realistic and conservative projections must be used. The appraiser should consider relevant factors that could affect the growth of the company over a certain period of time.
• Backsolve approach – When no recent transaction exists for the company, this technique is used to determine the value of the company’s common stock. The appraiser will analyze potential value drivers and conduct a series of calculations in order to derive the FMV of the common stock.

Does secondary trading impact the valuation of pre-seed-funded startups?

If the pre-seed funded startup has been trading on a secondary market, the valuation of the company will be affected. This means that the valuation of pre-seed funded startups can be affected by market fluctuations in the secondary stock market. Moreover, secondary trading might discourage potential investors from investing in a startup due to increased risks. However, proper strategies and instruments can minimize the risks associated with secondary trading.

Detailed Case Study: 409A Valuation & Pre-Seed Startups

Tech Corp is a software company delivering products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience. 

After developing their MVP, and having good traction among trial clients in the beginning, they were able to secure pre-seed funding from angel investors to expand their market.

• Here is a look at the cap table before the pre-seed funding:

The company then decided to take on its initial investment in the form of pre-seed funding, from investors. The total amount of the funding was $500,000 to support the company to develop its product and expand its market. With this investment, the share price buy-in was $0.166667 per share.

• Here is a look at the cap table after the pre-seed funding:

• A 409A valuation for pre-seed funded startups, as their funding round sets the pre-money valuation of the company for investors to invest, this also sets the share price for the shares.

• Then, conduct a backsolve approach based on the company’s cap table. To conduct the analysis, payout “Tranches” would be set up according to the amount paid back to investors, in this case, $500,000. The remaining amounts would be split according to the ownership percentage.
• These tranches would then be put through a stock option pricing model (OPM) to attribute values to each equity class.

• According to this cap table and the inputs, the common share price would be $0.065, or 39% of the pre-seed share price ($0.16667). If the company had a Discount for Lack of Marketability (DLOM) of 50%, then the final value would be:

• The 409A valuation process, considering the new capital, reduced risk, and progress toward product launch calculates the FMV of common stock.
• The new FMV of the common stock is determined to be $0.03 per share.

This is an example of how to get a 409A valuation for pre-seed-funded startups and find the common share value to be used for stock option exercise pricing.

FAQs

Here are some frequently asked questions about 409A valuation for pre-seed funded startups:

Why is a 409A valuation important for pre-seed startups?

Pre-seed startups need a 409A valuation to set the strike price for any stock options granted to employees or service providers. An inaccurate valuation can lead to adverse tax consequences for the company and recipients.

How is a 409A valuation calculated for pre-seed startups?

An independent qualified appraiser typically uses methods like calculating the startup’s assets, projecting future worth, or a backsolve approach to determine the FMV of the common stock. Since pre-seed startups have limited operational history, assumptions, and risk factors play a significant role.

When should pre-seed startups get a 409A valuation?

Pre-seed startups should obtain a 409A valuation before issuing stock options or equity compensation. The valuation should also be updated after major events like fundraising rounds, changes in business model, or significant shifts in financial projections that could impact the company’s value.

Can pre-seed funding impact the 409A valuation?

Yes, suppose a pre-seed startup receives external funding at a high valuation (e.g., $3 million for 20% equity). In that case, the 409A valuation must consider this transaction and the implied common stock value, even if discounts are applied. Selling preferred stock or using convertible debt can help manage high valuations.

What are the risks of an incorrect 409A valuation?

An incorrect or outdated 409A valuation can lead to tax penalties under IRC Section 409A for the company and equity recipients. Undervaluing the stock results in additional income tax liabilities, while overvaluing it means missed tax deductions.

Get 409a Valuation for Your Pre-Seed Startup from Eqvista!

Raising pre-seed funding for your startup can be difficult. However, it is important to remember that you need to have a good product or service, an attractive business model, a credible team, and the right network in order to raise pre-seed funding. A 409A valuation is also essential in order to determine the fair market value of a startup’s stock. Eqvista provides accurate 409A valuations for companies across the globe. Register with Eqvista now and build a strong foundation for your startup.

Eqvista provides expert 409A valuation services tailored for pre-seed startups. Their experienced professionals ensure an accurate and IRS-compliant valuation using appropriate methodologies like the Option Pricing Model. This qualifies for safe harbor protection, avoiding future tax penalties.