Role of Market multiples in 409A valuations post-funding rounds
In this article, we will recap the meaning and significance of 409A valuations and explore how the market approach for 409A valuations must be altered post-funding.
Through stock-based compensation, startups can attract key talents without depleting their limited cash reserves. However, if you do not get a 409A valuation when you offer such compensation, you could leave your employees exposed to agonizing tax liabilities. You must follow Section 409A guidelines in establishing your startup’s fair market value (FMV).
This endeavor becomes slightly tricky post-funding. Interestingly, the market valuation multiples commonly used in such valuations cannot be directly applied post-funding. This is because funding rounds fundamentally alter a startup’s growth trajectory.
In this article, we will recap the meaning and significance of 409A valuations and explore how the market approach for 409A valuations must be altered post-funding. Read on to know more!
What are 409A valuations?
409A valuations establish the fair market value (FMV) of a company’s shares when it wants to issue stock-based compensation to its employees and service providers. The stock option receiver’s taxable income will be calculated as the difference between the FMV and the exercise price.
You can think of your company’s FMV as the fair price for equity in a market where both parties know and understand key details about your company. You must not include any speculation in the FMV as speculations result from imperfect knowledge (not knowing key details), and imperfect understanding of key details.
The name ‘409A valuation’ comes from Section 409A of the Internal Revenue Code (IRC), which defines the tax treatment of various kinds of stock-based compensation such as some types of restricted stock units (RSUs), top hat plans which are also known as supplemental executive retirement plans (SERPs), excess benefit plans, and bonus deferral plans.
If you do not comply with Section 409A, your employees may face an immediate increase in taxable income, increased interest on unpaid taxes, and a penalty. This can snowball into the employees suing you for negligence.
Role of market multiples in 409A valuations
If you take the market approach to 409A valuation, you will need to calculate market multiples for certain financial metrics like sales and revenue and apply this multiple to your company’s financial figures to find your 409A valuation.
Understand this through an example
Suppose we want to use the market approach to find the value of BioVantage, a Series C health tech startup, and we have the following market data.
| Company | Sales | Valuation | Valuation multiple |
|---|---|---|---|
| VitalSync | $2,000,000 | $5,340,000 | 2.67 |
| Medivance | $3,200,000 | $13,856,000 | 4.33 |
| Healthora | $2,240,000 | $7,100,800 | 3.17 |
| BioNexus | $2,912,000 | $12,608,960 | 4.33 |
| CareVantage | $1,164,000 | $5,238,000 | 4.5 |
| Syncora Health | $4,659,000 | $13,511,100 | 2.9 |
| MediFusion | $1,400,000 | $4,830,000 | 3.45 |
| VitalisTech | $3,937,870 | $20,476,924 | 5.2 |
| CureNova | $2,940,000 | $12,642,000 | 4.3 |
| HealthSphere | $1,358,000 | $4,807,320 | 3.54 |
Now, we can calculate the market sales valuation multiple by dividing the total market valuation by the total market sales.
So, market sales valuation multiple = $100,411,104 ÷ $25,810,870 = 3.89
BioVantage’s valuation will be the product of the market sales valuation multiple and its own sales figure.
Suppose its sales stood at $3 million.
Then, BioVantage’s valuation = 3.89 × $3 million = $11.67 million
What changes post-funding?
Once you secure funding, your startup does not automatically become an enterprise of a completely different scale but it certainly has the means to do so. You will find yourself in a certain gray area. You will be tempted to count yourself among the bigger firms but before you do so, you must leverage the funding you received to scale up your operations.
So, after securing funding, startups will commonly take some of the following steps to get to the next level:
- Bring in key talent
- Explore new markets
- Increase investments in product development
- Increase marketing budget
- Improve distribution channels
- Solidify partnerships
- Strengthen customer acquisition
- Enhance infrastructure
The capital injection will also change the ownership structure and might increase management pressure. However, if you onboarded an investor with experience in your sector, you could leverage their expertise and network to boost your startup.
If a startup already had a product and needed the funds to scale operations, it could benefit from economies of scale.
How to treat market multiples post-funding in 409A?
When you apply the market approach post-funding, you must recalculate your financial projections. This adjustment must reflect the expected growth and the uncertainty in achieving said growth. We can summarize the difference in the market approach for 409A valuations as follows:
| Pre-funding | Post-funding |
|---|---|
Understand this through an example
Suppose your fintech startup, Flux Pay, just raised $10 million in Series A funding. Last year, its annual sales were $3 million. We also know the following details about other Series A fintech startups.
| Company | Sales | Valuation | Valuation multiple |
|---|---|---|---|
| Nexus Pay | $5,100,000 | $16,575,000 | 3.25 |
| Quantum Wealth | $3,570,000 | $12,852,000 | 3.6 |
| CryptoForge | $7,854,000 | $21,991,200 | 2.8 |
| Finovo | $3,141,000 | $9,423,000 | 3 |
| Swift Capital | $4,712,000 | $12,958,000 | 2.75 |
| Pixel Finance | $2,827,000 | $11,873,400 | 4.2 |
| Cobalt Trust | $4,284,000 | $12,852,000 | 3 |
| Zenith Money | $2,273,000 | $6,364,400 | 2.8 |
| Flux Banking | $2,356,000 | $7,421,400 | 3.15 |
| Cipher Invest | $3,298,000 | $11,213,200 | 3.4 |
Based on the earlier mentioned formula, market sales valuation multiple = $123,523,600÷ $39,415,000 = 3.13
Let us assume that Flux Pay’s sales can grow by a factor of 3.5 until its Series B round. So, its projected annual sales will be $10.5 million. However, 35% of startups that raise Series A funding will typically fail before their Series B funding round. So, let us adjust the annual sales projection to reflect this risk.
Flux Pay’s updated annual sales projection = (100% – 35%) × Previous projection
= 65% × $10.5 million = $6.825 million
Now, let us calculate Flux Pay’s valuation.
Flux Pay’s valuation = Annual sales projection × Market sales valuation multiples
= $6.825 million × 3.13 = $21.36 million
Before Flux Pay secured funding, we would have to apply the market sales valuation multiple for seed-funded startups at the actual annual sales to find its 409A valuation through the market approach.
Stay Ahead of Tax Laws With Eqvista’s 409A Valuations
409A valuations ensure tax compliance when you issue stock-based compensation like RSUs, excess benefit plans, and bonus deferral plans. One of the methods used for 409A valuation calculations is the market approach.
In the market approach, we must calculate the total valuation of similar startups to divide it by total market sales or any other similar financial metrics. This will be the market valuation multiple. When we multiply this by the startup’s financial figure, we will get its 409A valuation.
Once a company secures funding, it is more likely to move on to the next stage. So, its financial projection must be updated. However, we must also factor in the risks in these financial projections.
So, post-funding, if we want to use the market approach to calculate a startup’s 409A valuation, we must first adjust its financial figures to reflect the expected growth and risks involved.
If you have similar queries about 409A valuations, consider reaching out to Eqvista’s valuation team here. We are an independent valuation service provider that has served more than 15,000 companies.
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