409A Valuation for Series A Funded Startups

This article will examine the concept of Series A funding and the basic considerations for 409A valuations.

Funding early-stage startups are becoming increasingly competitive as the marketplace becomes more saturated. In the current economic climate, investors are constantly looking for scalable, profitable, and high-growth opportunities. As such, Series A funding is a part of seed stage financing that comes into play once the startup has built a solid foundation and an initial prototype. While the 409A valuation is a method of valuing a private company’s common stock under the Internal Revenue Code provisions. Often, 409A valuations are used when a private company raises money from investors, grants equity compensation, or establishes an Initial Public Offering. This article will examine the concept of Series A funding and the basic considerations for 409A valuations.

Series A funded startups

Before we get into the details of the Series A-funded startups, it’s important to define the term “Series A” in investment terminology. Series A funding is used to fund new ventures looking to scale and expand. Series A funding typically happens after completing an in-depth business plan, plenty of piloting and product testing, and market validation via customer feedback. Entrepreneurs will also begin to focus on their long-term strategy as they approach Series A funding.

As a result, Series A funded startups are typically considered to be growth startups or expansion-stage companies. These startups will often have already secured some initial funding through seed stage or pre-seed stage financing. The amount of capital raised by startups through Series A funding varies greatly as it is typically dependent on the market need, size, and scope of the business or product, and the team behind it.

What are Series A funded startups?

The term “Series A” refers to the basic seed round that startups receive in the early stages. The startups that secure Series A funding are referred to as Series A funded startups. These startups are usually in a growth phase and have already received a small amount of initial financing. The startup will still have a prototype or minimum viable product (MVP), but they’re already securing funding on the heels of strong market testing results and positive early customer reviews.

Many startups in this stage will also have tangible evidence of demand for their product or service as well as compelling metrics to show for growth. However, it totally depends on the startup and the stage of development that they’re in. Thus, the amount of capital raised by a series A funded startup will vary. Continue reading to know more about when a startup should raise its Series A funding.

When to get Series A funding?

As a general rule of thumb, Series A funding is typically completed at the beginning of the growth stage. In many cases, the Series A startups will have a lot of runways to grow and expand over the next few years. Here are a few indicators that show when a startup should raise its Series A funding:

  • When you have a compelling business model – When a business has a high-value model and solid growth potential, it may be a good idea to raise your Series A funding. If your startup generates revenue, has clear and compelling metrics, and has proof of demand, you may have already established a strong business model. Furthermore, if the market potential or market size is large enough to support the business model, you may want Series A funding. Overall, your business model should be able to support the amount of funding that you’re looking for. If your business model is compelling enough, then a strong pitch deck is all that you will require.
  • You want to raise $2 million – $5 million – If your startup is looking for between $2 million and $5 million, then you will definitely want to raise Series A funding. As a result of the high capital requirement, you will want to ensure that your business will bring in enough revenue to cover this investment. You’ll also need an excellent team behind your company as well as an outstanding leader who can bring in the investor’s interest.
  • You are ready to give enough equity – Know that Series A startups are typically seeking equity-based funding. Consequently, the dilution level and the amount of equity being provided to investors will vary. As such, startups should be fully prepared to give enough equity to investors as a result of the funding. Thus, you’ll want to calculate the equity with care and caution due to the fact that high-level dilution in the ownership can result in a loss of control.

Challenges in raising Series A funding

Although raising Series A funding can be quite challenging, it’s still important to make a pitch deck that is both compelling and impressive. You will want to make sure that you’re providing your investors with the proper amount of information about your company, as well as the market. Following is a list of the most common challenges that startups will face when raising their Series A funding:

  • Unqualified team – In order to raise money, you should have a team of professionals behind your company. In fact, you should have a team that has the right mix of strengths and skill sets to take your business to the next level. In other words, an unqualified team can hinder your fundraising efforts by putting off qualified investors. As such, it’s crucial that you put together a team of professionals who have demonstrable track records for success.
  • Cost of customer acquisition – For your startup to grow, you will have to invest in customer acquisition and new revenue channels. Most Series A investors are interested in companies that have large market potential, solid growth potential, and a proven business model. The greatest challenge here will be in distinguishing your business from your competitors. Consequently, you’ll want to make sure that your startup’s marketing strategy is designed to help you achieve your short-term goals while establishing a long-term foothold in the market.
  • Talent acquisition – Hiring talent for startups can be challenging, especially when it comes to finding the right fit for certain roles. Series A investors will want to ensure that your startup has the right management team to support rapid growth. As such, finding the right talent for your business regarding management and operations is crucial. Likewise, you’ll want to make sure that your team is always up-to-date with the latest industry trends and news.
  • Product credibility in the market – When it comes to product credibility, you should know that you need to prove the demand for your product based on the latest data. Otherwise, you can lose out on many investment opportunities, which can be detrimental to your startup. Consequently, it’s essential that you demonstrate compelling evidence of growth in the market, which will help you secure funding.
  • Pitching to the right investors – Whenever you’re looking for funding, it’s important that you pitch your business to the right investors. As a result, it’s crucial to do your research in order to find the investors who are likely to be interested in your company. This research will likely take some time to complete, but the effort will be well worth it once you find the right investor to invest in your company.

How to get Series A funding for your startup?

So, how do you get Series A funding for your startup? As a result, it’s essential that you think carefully about your company’s needs, size and budget. To get started, you’ll want to prepare a pitch deck template, which includes the following key elements:

  • Executive Summary
  • Market Analysis
  • Competitive Analysis
  • Product Analysis
  • Expansion Strategy and Key Milestones
  • Financial Forecast and Funding Requirements

You’ll also want to make sure that you have a great elevator pitch that’s fully prepared for your investors. In addition to this, conducting business valuation is absolutely critical. It will allow you to determine your financial health, thereby helping investors to see your company as a potential investment. Overall, these steps will help you to ensure that you’re able to raise your funding in a timely manner.

409A valuation in Series A funded startups

The 409A valuation is considered by many investors as one of the most critical steps in the Series A funding process. It’s a provision in the Internal Revenue Code (IRC) that defines the fair market value of common stock for privately held organizations. 409A valuation will usually be done by experts well versed in financial reporting or by a qualified attorney with experience with this type of provision. Do startups need a 409a valuation at Series A funding stage?

Do Series A funded startups need a 409A valuation?

It’s important to note that 409A valuations should be performed on all common stock that is issued by a private company. Moreover, this measure can be used to issue equity grants to employees, consultants, or advisers. During the fundraising process, the need for a 409A valuation will be determined by investor requirements, and they may ask the company to prepare a valuation of all common stock at the time of the proposed transaction. As a result, if the company has prepared a 409A valuation and it’s compatible with their interests, it can add value to the company and accelerate the funding process.

When do Series A funded startups need 409A valuation?

A 409A valuation should be performed in accordance with the facts and circumstances of every situation, including:

  • At the time of presenting the company to potential investors, 409A valuation may be utilized to help secure company funding in a timely manner. Typically, venture capitalist investors will be more interested in acquiring private companies that have a fully prepared 409A valuation.
  • In scenarios in which a company has issued common stock to employees, consultants, or advisors, a 409A valuation should be performed in order to provide an accurate and authoritative measure of common stock.
  • The provision of IRC 409A requires that the company stays compliant with its provisions, and it requires a compliance review every year. This requirement ensures that the company stays in line with federal and state securities laws.

How does 409A valuation work for the Series A funding stage of startups?

Now that we have a complete understanding of what a 409A valuation is, let’s take a closer look at how it works for Series A funded startups. Here are a few things to consider:

  • Calculation of FMV – Determining the fair market value of your company’s common stock plays a crucial role in financial transactions, such as the granting of stock options. Unlike public companies, the stock is not listed with the government or traded on an exchange. Consequently, determining the FMV of your company’s stock through 409A valuation for series A funded startups can be beneficial.
  • Independent evaluation – In 409A valuation, the company should provide the investor with an independent appraisal that’s free from impermissible self-dealing. This appraisal should be approved by a disinterested third party, as defined by Section 409A of the IRC. As a result, it provides a transparent and objective appraisal of the value of your company’s stock.
  • Backsolve approach – Companies with complex capital structures can benefit from the backsolve approach, which is a valuation method that allows the company to apply 409A valuation. The backsolve approach will enable the company to determine the correct value of a company’s common stock through an analysis of recent investment rounds.
  • Calculation of price of common stock options – Issuing stock options to employees, consultants, or advisers can be a great way to keep them motivated and committed to your business. In this regard, a 409A valuation can be utilized to determine the value of stock options, which is critical when it comes to incentivizing employees.

How to set up the right valuation for a Series A funding round?

Well, if you’re planning on raising a Series A funding round, you’ll want to ensure that you provide them with a fully prepared business valuation and 409A. It’s important to note that your valuation should be realistic and based on the most recent transaction with similar characteristics and features.

As such, projections, assumptions, and calculations should be conducted in a reasonable manner, depending on the facts and circumstances of your startup. Various methods and approaches can be used to produce accurate results. Thus, consulting with a professional and experienced accounting firm that can deliver the right results is recommended.

409a valuation case study for series A funding rounds

Let’s say there is a company called Docurato. that specializes in software for documentation purposes. After making sizable gains in the market and its first 1-2 years of sales, but still unprofitable, the company looks to get Series A funding from VCs to support their operations further. With pre-seed and seed investments already with the company, the company has a good track record with investors and is looking to add more to the company funding.

Here is a look at how their cap table looked like before the Series A funding:

Series A funding cap table

The company then decided to take on its initial investment in the form of a seed funding round from angel investors. The total amount of the funding was $9,600,000 to support the company in developing its product and bring it to market. With this investment, the share price buy-in was $2.4 per share. Here is a look at the cap table post-funding:

Increase ESOP from 1,500,000 to 1,944,500 to maintain a 10% ESOP for employees and for increased options for incoming staff in the coming 12 months.

409a valuation for Series A funded

For a 409a valuation for Series A funded startups, as their funding round set the pre-money valuation of the company for 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 $9,600,000 investment. After this, the remaining amounts would be split according to their ownership percentage.

ownership percentage

In this case, 100% of the payout from 0 to $12,000,000 would be paid to the pre-seed, Seed, and Series A investors. The remaining tranches from 2-6 would be according to each breakpoint when the equity holders 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 $0.81 after DLOM, as:

Common Share price: $0.81

This share price would reflect around 30% value after DLOM of the seed funding round of $2.40. This is an example of how to get a 409a valuation for Series A-funded startups and find the common share value to be used for future use, such as stock option exercise pricing.

Get a 409a valuation for a series A funding round with Eqvista!

This article has provided a brief overview of the basic concepts and important details regarding the Series A funding process, particularly the 409A valuation. In this regard, we have provided useful insights that will help you to understand what 409A valuation is and how it works for Series A-funded startups. Eqvista provides accurate 409A valuations that are tailored and compliant with the requirements of private companies. The team of experienced and accredited professionals at Eqvista can assist you in the process of 409A valuation.

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