Do Venture Capitalists Use a 409A Valuation to Value a Startup?
Is your 409A value different from the venture capital appraisal done by your investor, and you’re not sure why? VC valuations and 409A valuations are extremely distinct from one other, even though this may not be widely known. In reality, 409A values are point estimates at the lower end of a defensible valuation range compliance professional conduct. On the other hand, VC valuations are the market values that entrepreneurs and venture investors agree upon (VCs).
In contrast to VCs, 409A valuation providers almost always use venture capital valuation as an input to their valuations. Unsure where this is going? Let’s delve deeper into the subject to gain a better grasp of it.
409a Valuation and Venture Capitalists
It is important to remember that there are at least two separate valuations that startup owners should keep in mind throughout the life of their company. Interested investors’ perceptions of the company’s worth are the first consideration in any financing round. To begin with, the founder will require a 409A valuation from a third party before granting stock options to employees.
It is crucial for venture capitalists to understand how the 409A valuation works. As a part of this guide, we’ll explain the importance of 409A valuations, as well as the process of determining them.
Understanding 409a Valuation
An independent third party appraises the fair market value (FMV) in a 409A valuation. These assessments are often paid for by startups, which then use the findings to determine the price at which employees can buy shares of the company’s equity. Founders and employees of a firm own common stock, which is the portion of the company’s stock that is owned by the general public.
Why is a 409a valuation important for startups?
Private companies require a 409A valuation in order to grant tax-free stock options to employees (often a useful recruiting tool).
Tax code Section 409A governs nonqualified deferred compensation schemes, and the term “409A valuation” refers to a calculation of that value (e.g., stock options). The legislation compels private enterprises to set an exercise price (i.e., the price at which employees can acquire shares of their common stock once the shares have vested) that may never be less than the FMV of the company’s shares on the date the stock right is granted.
A private company’s common stock isn’t traded on a public stock exchange, so a 409A valuation is required to determine its worth.
At the time of grant, the IRS requires a “reasonable means” of determining FMV. One technique to ensure that the value of a company’s common stock is deemed to be “reasonable” by the IRS is to use an independent third party to determine the FMV of the stock every 12 months. The IRS refers to this as a “safe harbor” for the corporation if a fair valuation approach is used.
There may be a significant tax penalty for failing to use a valuation safe harbor. All future deferred remuneration for current and previous year employees could be subject to an additional 20% tax penalty if the IRS finds the value to be unjustified.
Requirements for 409a Valuation
An independent 409A appraiser with experience evaluating businesses in the same industry as the one being evaluated is hired by firms to create a reasonable presumption. An early-stage company might expect to pay anything from $1,000 to $5,000 for a 409A valuation (varies depending on the size and complexity).
The following information is routinely requested of the company during the 409A valuation process:
- Incorporation papers,
- The most up-to-date list of capitalizations
- The company’s presentation deck,
- Financial information (P&L statements, bank statements, etc.),
- Agreement for the purchase and sale of stock (if any),
- Based on the company’s recruiting plan, this is an estimate of how many stock options they expect to issue in the coming year.
- Important developments since the last 409A valuation (anything that may have an effect on the stock price) have occurred.
- Predictions of future liquidity occurrences (e.g., an acquisition, IPO, etc.).
The fair market value (FMV) of a company’s common stock is typically calculated by an appraiser using the “market” 409A valuation procedure. Financial data from a collection of publicly traded companies, including stock price, sales, and EPS before interest, taxes, and depreciation/amortization (EBITDA), will be used in this analysis.
Preferential shares will also be taken into account by an appraiser. This is a type of stock that is provided to investors that gives them some degree of control over the direction of the company.
As a result, to account for the stock’s low marketability, the appraiser reduces the price of the common stock. When a company is nearing a liquidity event, the discount rate is lowered to reflect this.
Prior to issuing stock options, a company’s board of directors is normally required to accept the most recent 409A value. Every year, in order to keep its safe harbor status, a business must “renew” its 409A value. A company’s 409A will also need to be updated if and when:
- The corporation plans to issue common stock options.
- When a firm experiences a “major event” (Eg; funding or a new business plan), the company’s stock price rises.
- The company is on the verge of going public, merging, or being acquired.
Who are Venture Capitalists?
A venture capitalist is a person or organization that contributes money to the start-up or expansion of a firm. Venture capital is mostly provided by professionally managed companies. As a result, venture capital firms are looking for better returns than they would get from the stock market.
Large investments in a promising startup or early-stage company define venture capitalists (VCs). While venture capitalists might work alone, it is more customary for them to be employed by a venture capital business that pools money from its members for their benefit.
Valuation Requirements for Venture Capitalists
There are a number of assumptions that go into the venture capital process of valuing a company. Valuation methods aren’t all the same. Assumptions allow for a lot of room for interpretation. And since you are the company’s founder, it is imperative that you understand the fundamentals of the business. A better understanding of what is happening will allow you and your investors to debate several possible outcomes. Listed below are the formula requirements for the valuation process:
- Post-Money Valuation (version 1) = Shareholders’ Equity x VC Investment Price Per Share
- Post-Money Valuation (version 2) = Pre-Money Valuation + Investment
- Post-Money Valuation (version 3) = Price Per Share the VC Paid * Total Number of Shares Outstanding after the Round
- Investment = Price Per Share the VC Paid * Number of Shares the VC Bought
- Pre-Money Valuation = Post-Money Valuation – Investment
409A Valuation vs Venture Valuation
Let’s take a look at the main differences between 409A values and venture valuations.
- Valuation Technique – Demand in the market drives pre/post-money valuations, which do not typically take the company’s 409A valuation into account. However, 409A valuations are assessed by an independent third-party appraiser and based on the company’s post-money worth.
- Kinds of Stock – 409A values are based on the stock’s market value. Venture capitalists, on the other hand, usually obtain preferred stock.
- Compliance – To withstand an audit by the Internal Revenue Service, 409A valuations must meet regulatory standards. The same rules do not apply to pre-and post-valuations.
- Shift in Value – The 409A value and pre-and post-money valuations are both subject to alter over time. The pre/post-money valuation, on the other hand, is based on the premise that all shares have the same worth. As a result, seed investors will see the value of their shares fluctuate based on the company’s valuation at the beginning of Series A. When an employee is granted stock options, the exercise price is the same as it was at the time of the grant.
409a valuation for venture capitalists
Investors rarely discuss the 409A price except when the board votes to accept it. VCs have a lot of experience and knowledge. They are well aware that the 409A cannot be used against a founder and that the company’s goal is to keep prices low at all costs. Keep reading to know more.
Is a 409a valuation important for venture capitalists?
The pre/post-money value of a business isn’t heavily influenced by the 409A valuation for two reasons:
- Venture capital valuations are frequently influenced by the state of the market. Investor demand has a significant impact on how much a business may raise.
- Preferred stock is awarded to venture capitalists. The value of this stock is based on the fact that it comes with additional benefits and privileges that aren’t available to regular stockholders.
The price per share will rise as a result of these factors. An employee’s cost of exercising his or her options will be lower than that of a venture capitalist.
Pre/post-money valuations, on the other hand, have an effect on 409A appraisals. If a company recently raised a considerable amount of money, an appraiser is likely to raise the company’s 409A valuation. Increased exercise prices for employee stock options may have a negative impact on investors.
Additionally, VCs can learn a lot about a company’s 409A valuation strategy by looking at how they approach it. Companies and their employees may be exposed to enormous risk if their founders fail to take the necessary procedures to secure a safe harbor. The tax penalties on employee stock options could cause a mass exodus of talent if the IRS takes action against the company.
A bad 409A practice could also jeopardize an acquisition. Regulations, banks, and legal counsel will scrutinize option issuances if the company intends to IPO. It could have a detrimental impact on the company’s management and on potential investors if any are found.
Why do venture capitalists not use 409a valuation to value startups?
The 409A appraisals are vastly different. For tax purposes, they provide an IRS-defensible valuation. Keep in mind, however, that these assessments tend to fall on the lower end of the permissible price range.
In general, a 409a valuation has no bearing on the process of calculating a VC value. Investors know that 409A valuations are compliance-focused and will be at the bottom end of an allowed range. However, many venture capitalists (VCs) do not believe that a 409A valuation business can accurately estimate the underlying value of a company. Valuation is a basic competence for venture capitalists, and the consequences of their business’s value decisions are enormous. As a result, they will not entrust this decision to a third party.
How can Eqvista help with your preferred business valuation?
If you come across an investor that wants to evaluate your firm on their own and obtains a value that differs from the 409A valuation, you’ll know why. Remember to use a cap table while negotiating with the VC to maintain track of your company’s shares. We at Eqvista can assist you. We offer numerous business valuations; including 409A valuation done by our NACVA certified analysts. Contact us now to learn more about our valuation services.