409A Valuation for Seed Funded Startups
This article will share with you the importance of a 409A valuation for seed funded startups.
An influx of startups has created an unparalleled period of growth and increased investment opportunities. As the number of innovative startups continues to grow, the investing climate and resulting company valuations have changed dramatically. Seed funding for startups has become more common as a result of easy access to funding and the rapid development of technology. While 409A valuation is conducted in order to determine the fair market value of the common stocks, it is primarily intended for private companies. As such, various valuation approaches and techniques may be utilized in order to reflect the accurate financial position of the business. This article will share with you the importance of a 409A valuation for seed funded startups.
In recent years, seed funding has become a popular method of financing early-stage startups. The term “seed funding“ refers to the initial investment, usually in the range of between $500,000 to $2 million; however, this number may vary between companies. Seed-funded startups are typically newly-established companies and may not have mature financial statements, but the intent is to provide the funding needed to develop a prototype or proof of concept.
The initial investment, while relatively small in comparison to typical investments made in mature companies, provides the startup with enough capital to move forward with the initial business concept until more substantial financing is available. Seed funding provides a great deal of risk, as there is a high likelihood of failure for the business, although this risk is borne directly by the investors. Thus, seed-funded startups are typically small and are in their initial stages of development.
What are seed-funded startups?
The startups that receive seed funding are typically early stage, with limited financial resources and cash flow. The capital invested provides the founders with the necessary funds to develop a proof of concept or prototype to showcase their core product or service. Basically, seed-funded startups are immature businesses with limited financial data and no established sources of income. These startups are new and unproven, and funding provided is generally used to jumpstart their growth and development.
The deployment of initial capital and the function of the business concept is fundamental to the business’s success. The goal of seed funding is to invest in emerging companies with high investment potential that have the ability to grow while offering a high probability of market success. As a result, seed-funded startups are still in the early stages of development, and the injection of seed funding is the catalyst that enables their initial growth.
When to raise seed funding for your startup?
The decision to raise seed funding is largely based on the maturity of your business. In general, seed funding is a good idea after you have finalized and executed your business plan and have reached the conclusion of a favorable potential market. Following are some of the general recommendations on when to raise seed funding:
- To promote products – Seed funding is the most efficient method to bring your product or service to market. The funds will allow you to reach your target market, which in turn will be your primary source of revenue and financial support. When you reach the point in your business plan where you need to gain traction with a focus group, target demographics for testing, or other methods of spreading awareness about a new product or service, it’s time to raise seed funding.
- To work with experts – Some seed-funded startups require expert advice and involve the participation of mentors in order to develop their products and services. Hiring experts to assist in the development stage is an important consideration. However, the cost associated with hiring experts can be very high, and that’s where seed funding can help. It can be used to assist in the development stage of the business while providing capital to make it a viable company.
- To implement a prototype – A business plan will typically include a prototype or proof of concept, which is usually the first product that the company will develop. Reaching this stage can be costly and often involves hiring a team of developers to carry out the task. Accessing seed funding at this point can be crucial to ensuring the viability of your business. Thus, building a prototype serves as a basis for more substantial investments later on, and seed funding can serve as the initial investment required to get your product from idea to reality.
- To build relationships with investors – When you have a well-developed business plan, product or service, a prototype that is tested and ready for distribution, and an audience or potential customers to whom you can market your product; it’s time to begin the process of seeking out seed investors. It helps to establish a foundation of relationships that will lead to connections, introductions, and possible contacts.
Challenges in raising seed funding
Although seed funding is ideal for many startups, it still requires careful consideration. There are a few challenges raised by many startup founders that prevent them from raising seed funding. Here are some of the general challenges of raising seed funding:
- Building a unique business model – In this competitive and demanding environment, the creation of a unique business model is essential in the startup industry. One of the major challenges with seed funding is developing a model that is not just unique but also sustainable, profitable, and scalable. It should be something that investors find attractive, and you should be able to offer them something unique to invest in and gain substantial interest. You must consider how your service or product differs from others and how you can use this difference to develop a strong business model.
- Deciding how much money to raise – When you decide to raise seed funding, you want to make sure that you cover the maximum amount of capital required for the growth of your business. The best bet is to determine the amount of money you feel you can raise within a reasonable length of time, realistically, based on your business plan and the milestones associated with it. Proper budgeting and financial planning help you reach your business plan’s objectives, which will give you a sense of direction.
- Selecting the right funding option – There are multiple options for raising seed funding for your business, and it is important that you select the one that best suits your business. From venture capital firms to angel investors and private equity, it’s important to carefully consider which option is appropriate for your startup. Planning and preparation are key when it comes to selecting the right funding option.
- Where and how to spend raising funds – The amount of money that you raise will ultimately determine the specifics associated with your business plan, and it is important that you spend the money wisely. You will have to make sure that you divide your funds accordingly and spend them in the correct areas of your business, including marketing and advertising, funding new operations, hiring employees and consultants, and more. Allocation of funds is essential to the success of your business, and it will determine how well you are able to meet your financial goals.
How to raise seed funding for your startup?
Once you’ve determined that raising seed funding is the correct option for your startup, it’s time to figure out how to go about raising seed funding. Make sure that you have done your research and are familiar with the costs and terms that are associated with investing in startups. Here are a few tips for raising seed funding for startups.
- A business plan plays an essential role in order to secure funding from investors. It should include a thorough explanation of the business idea, the associated financial plan, and the overall potential for growth.
- Conduct business valuation and 409A valuation before raising money from investors and potential partners. It helps to gain insight into the potential of the business, whether it is viable or not, and it helps to gauge a potential investment.
- Prepare a pitch deck to present your business plan to potential investors. It should include a detailed overview of your business model and the key driving factors that will help you to reach your goals.
- Building a network of potential investors and mentors is essential for obtaining seed funding for startups. Networking with business professionals will give you an opportunity to build important relationships that can help you to secure funding for your startup.
- If you decide to raise seed funding, it’s important that you conduct a market study. A market study helps you identify the right investors interested in your product or service.
- Once you have determined that seed funding is the best option for your startup, then it’s time to narrow down your search and select the right investors. It’s crucial that you find the right match when it comes to the type of investor you want to work with and the style that fits your business model.
409A valuation in seed-funded startups
409A valuation is performed in order to identify the fair market value (FMV) of a private company’s stock. Determining the FMV of a company’s stock can be used for a variety of purposes. Seed-funded startups will typically need to determine the FMV of their company’s stock in order to make decisions regarding funding, ownership, and selling shares.
Does a seed-stage startup need a 409A valuation?
Yes, a seed-stage startup typically needs a 409A valuation in order to make the appropriate decisions regarding its business and funding. If you are considering raising seed funding, then it’s very likely that a 409A valuation will be required by your potential investors. In addition to this, various other financial transactions require a 409A valuation. However, it is essential to note that it is not mandatory for a startup to obtain a 409A valuation before raising money from investors.
When do seed-stage startups need a 409A valuation?
Seed-funded startups should perform a 409A valuation in order to determine the proper fair market value of their company’s stock. As seed-funded startups are in the early stages, hiring top talent can be done through equity grants. In this case, a 409A valuation will allow the startup to determine the fair market value of its shares.
Additionally, investors look at a 409A valuation as an indicator of how much a company is worth. By valuing the shares, a seed-funded startup will be able to attract investors who are looking for opportunities to invest in high-growth companies. Basically, a 409A valuation lets a startup determine its shares’ value, allowing the startup to attract investors, aid in future growth, and make key business decisions.
How does a 409A valuation work for seed-stage startups?
Various methods and techniques can be used for a 409A valuation. Following are a few standard approaches used during a 409A valuation of a company:
- Income approach – The income approach involves the projection of cash flows for a set period of time, usually 5 years. It assumes that the company will continue operating at a constant revenue rate and profit margin. The cash flows projected are then discounted at a discount rate, thereby determining the present value of future cash flows.
- Asset approach – The asset approach determines a company’s common stock value by estimating the worth of its assets. All tangible and intangible assets are considered, including patents, equipment, machinery, and more, in order to determine the value of a company’s stock.
- Cost approach – Considering the comparable public companies that exist in the same industry, the cost approach assigns a value to the company’s stock by comparing them to the company in question. This way, the comparables are used to determine an FMV of stock.
- Backsolve approach – The backsolve approach is used when the company’s capital structure is complex. FMV of stock is determined by considering the most recent price paid for an investment in preferred shares.
Can competitors affect your valuation at the seed stage?
The seed stage is typically considered to be the beginning stage of startups. It is the most sensitive period for startups, as there is a significant risk of failure. During this time, competition can be very fierce, and it can affect a startup’s success. The seed stage is one of the most important stages for startups, as it gives an opportunity to test their business model, receive feedback from potential investors, and receive investment from them.
If the competition is intense in the seed stage, the value of your investors’ equity may come down because of the increased risk of failure. Therefore, it’s important to be aware of the competition and the potential for dilution when it comes to valuation at the seed stage.
409a valuation case study for a seed-stage startup
Let’s say there is a company, called Dessin, which specializes in state-of-the-art design software for beginners. After the launch of their product to the market and gaining their first clients, they were able to secure further seed stage funding for the company. This would be used to expand their growth and increase operations.
Here is a look at what their simple cap table looks like before the seed funding:
The company then decided to take on its initial investment in the form of a seed funding round, from Venture Capitalists. The total amount of the funding was $2,000,000 to support the company to develop its product. With this investment, the share price buy-in was $0.80 per share. Here is a look at the cap table post-funding:
For a 409a valuation for seed funded startups, as their funding round set the pre-money valuation of the company for the VCs to invest in, this too set the share price for their shares.
Therefore, we can base off this scenario to conduct a backsolve approach based on their cap table. In order to conduct this analysis, payout “Tranches” would be set up according to the amount paid back to investors, in this case on their $2,000,000 investment. After this, the remaining amounts would be split according to their ownership percentage.
In this case, 100% of the payout from 0 to $2,500,000 would be paid to the Seed and Pre-Seed investors, and the further tranches based on the payouts when each type of equity holder would be paid out. 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 $0.48. If the company had a Discount for Lack of Marketability (DLOM) of 50%, then the final price would be:
Common Share price: $0.24
This share price would reflect around 30% value after DLOM of the seed funding round of $0.80. This is an example on how to get a 409A valuation for seed-funded startups, and find the common share value to be used for future use, such as stock option exercise pricing.
Need a 409A valuation for your seed-funded startup?
The goal of any seed-funded startup is to get the company off the ground with a solid foundation. The seed stage is the opportunity for a startup to test its business model, test its value proposition, and find investors for its business. Consequently, it’s crucial that the valuation of a seed-funded startup is done with care and accuracy. Get your 409A valuation for seed-funded startups from Eqvista today. At Eqvista, they pride themselves on being the leading business valuation experts and will ensure that your company is valued accurately and fairly.