409a Valuation vs Venture Capital (VC) Valuation

Did you just have your 409A valuation done and wondering why it’s different from the venture capital valuation done by your investor?

Did you just have your 409A valuation done and wondering why it’s different from the venture capital valuation done by your investor? While it may not be common knowledge, but both VC valuations and 409A valuations are very different from each other. In fact, 409A valuations are point estimates at the low-end of a defensible valuation range that is performed by compliance experts. On the other hand, VC valuations is the market value negotiated between entrepreneurs and venture capitalists (VCs).

While VCs usually do not consider a 409A valuation as an input into their valuations, 409a valuation providers almost always consider the venture capital valuation. Still a bit confused? Let’s dive deeper into the topic to understand more.

Valuation: Basics (FMV)

If you are reading this, you may already have an idea of what a valuation is. To start off, valuation experts consider the value of an asset to be its fair market value (FMV). And the IRS defines the FMV as the price at which both the buyer and seller are ready to make a deal on the property, where neither of the party is forced to make the deal and both have the needed facts and knowledge about the property.

With this definition, there are three main things that can be understood:

  • Valuation of a property is the price of the transaction between the buyer and the seller of the property
  • There is no compulsion for either party to buy or sell the property
  • Both the parties have all the details and the information needed about the property

Let us talk about the second two points first.

#1 No Compulsion

As per the definition, the transaction is not considered “fair” if one party is forced into the deal. For instance, let us say that a person Todd blackmails Sarah to sell him her house. The price at which Todd buys the house would not be the same as what Sarah would have listed his house for. So, as per the IRS definition, this transaction is not considered as a “fair”. And the value of the house would not have been sold at the FMV.

#2 Reasonable Knowledge of Relevant Facts

The next point states that both the buyer and seller should have a “reasonable knowledge of relevant facts.” To explain this, let us assume that you do not have the best personal ethics, and you want to sell your car that has a broken air conditioner. To fix this problem, you will need to spend at least $5,000. So what do you do?

Well, if you do not care about personal ethics, you can show the car to a buyer in the winter time and not tell them anything about the A/C problem. And you can easily sell off the car at full-price to the buyer. But in case the buyer learns about the problem with the A/C later on, they would insist on a lower price, or refuse to buy the car. As this deal was not made in good faith, and in order to get a better deal, you did not tell the buyer all the relevant facts of the deal.

In short, this is an example of information asymmetry. Information asymmetry happens when a party has relevant information that they want to hide from the other. And in such a situation (as the example shared above), the negotiated value of the house is not considered fair.

#3 The Price of a Transaction Between a Seller & Buyer

Now back to the main point. The fair market value of a property is the price at which the buyer and seller agree to make the deal on the property. In theory, this means that we can easily find out the value of something just by buying or selling it (as we assume that it is a fair deal). And from this, we would have the correct price of the asset, right? Not really. In the real world, both parties would want an estimate of the value of the property being making the deal, as it may not be sold at the true fair market value.

So, with this, why don’t we look up what other people have paid for something similar? Well, its a good start. Let us say that you want to buy a second-hand Toyota car and to be sure that you paying a good price for it, you look in your neighborhood and find out what others had bought the same car with the same condition for. Nowadays, you would probably use the blue book value from some site online, to find the best price.

It is common for buyers and sellers to want an estimate of the value before they complete the transaction. So, to get a valuation of something, we usually rely on the value of similar assets. And these similar assets are called “comparables.” Valuation professionals use the comparables to get the fair market value of assets in the market. But things become difficult when you need to get the value of something not commonly traded.

In such a case, how would get the estimate for this?

Let us take an example to understand this more. Assuming that we have a Picasso painting that you want to sell or get the estimate for. The piece is an original and there aren’t any other such sales in the market. So, how do you get the value of this piece? Well, we can look into the previous transactions for the painting.

But again, we know that the valuations usually increase over time for great art. So, here is what we would have to look into:

  • The recent sales of the other Pablo Picasso painting.
  • Recent sales of the other masterpiece paintings.

A lot of issues come up while we work on estimating the valuation from infrequent transactions. In fact, a small change in the market can easily influence the price in a huge way. For instance, a person who loved Pablo Picasso’s paintings can sell off their company and now wants to buy a new one. This means that two huge things affect the reliability of a valuation estimate, frequency and comparability.

Comparability refers to how similar one of the assets is with the other. So, the best way to get an estimated value of an asset would be by checking the recent sale of the very same asset. On the other hand, the frequency refers to how recently and often the comparable asset sells. A bottle of water is sold in millions within a day. So, you can be sure about the price of a bottle. When the comparability is high and the assets sell often, our certainty of the value of a similar asset is also high.

When comparability is low and comparable assets sell infrequently, we can’t be too sure of the value of an asset. So, the valuation professionals normally use valuation ranges to handle the lack of certainty. Due to this, it is possible for two people to sell the same asset for different prices. The next section would explain better about valuation ranges.

Valuation Ranges

While we deal with uncertainty, you would need to setup some confidence intervals. Confidence intervals mean that we can say that value lies in a range with some degree of certainty. For instance, Sam is 90% confident that the temperature tomorrow would be between 80 and 90 degrees Fahrenheit. The same thing can be done when we have valuations that are uncertain.

Moving onto company valuations, private companies are much harder to value than public ones. As public companies are traded on the market, their market price is a good indicator of their FMV.

That is when the investment bankers created an approach to value private companies using confidence intervals. Basically, they use a chart where it shows the valuation ranges for a company using different valuation approaches. And the valuation ranges would offer useful estimates even in uncertain situations, like valuing a private company.

Valuing Companies

As shared above, we know that getting the value of a public company is very easy. Everyday investors buy and sell thousands of shares on the stock market, which are fair transactions as both sides have the same public information and there isn’t any compulsion to trade. That is why they are considered as accurate prices.

However, valuing private companies are much harder. First, there may only be a few stock transactions that you can look at. Secondly, a lot of private companies are growing and changing at a fast pace, so the estimates of the value need to change. That is why there are a lot of methods for valuing companies. But most of the methods are a combination of 3 accepted approaches as shared below:

  • Market Approach: Getting the value of the business by looking at the value of the comparable companies.
  • Income Approach: Getting the value of the company by estimating the value of its future cash flows.
  • Cost/asset Approach: Getting the value of the company by adding all the costs of rebuilding the company or its assets.

409A valuation professionals consider these methods while they are valuing a private company. Using these approaches, they build up complex financial models. On the other hand, VCs value companies using their experience, gut feel and the Venture Capital Method, which is also known as the “First Chicago Method”.

Let’s now move onto the differences between the 409a valuation methods and the venture capital valuation method.

409a Valuation & It’s Methods

During the early 2000s, the US government established the laws around common stock options. With this came the new section of the internal revenue code called the IRC 409A. The main idea of the 409A was to make it costly for businesses to issue stock options below the FMV.

But the regulators did not want the rule to overly affect startups too much. Hence, they created an option for startups to have their 409a valuation done by an independent valuation firm. With this, startups would get a safe harbor status and eliminate most of the 409A risks.

There are a lot of 409A valuation methods that are used, but the most common ones include:

  • Discounted Cash Flow Analysis: This uses the projected cash flow of the company to get the valuation.
  • Asset / Cost-to-Recreate Approach: This uses the value of the assets of the company or the cost of purchasing similar assets to get the valuation.
  • M&A (or Transaction) Comparables Analysis: This 409A valuation method uses the transaction acquisitions of other companies to get the valuation.
  • Public Comparables Analysis: This uses public companies to get the valuation.
  • Backsolve Option Pricing Model: This uses the most recent sales of the preferred stock to get the valuation.

Based on the company type, age, size, and industry, the 409A valuation professional picks up the most reliable method to get the valuation of the company. At times, the evaluator can also weigh a few approaches to get the weighted average estimate. For instance, valuation professionals can weigh 4 valuation methods at 25% each, including – Backsolve, M&A comps, Public comps, and Invested capital, if each of these methods produces drastically different estimates.

The IRS needs the 409A valuation to get a point estimate of the value of the common stock of the company, which is a single-number approximation of the value, as opposed to a range of values. And the 409A valuation professional usually picks the point estimate that is towards the low end of a defensible range of values. This is done because many clients want the valuation to be as low as possible, so they can grant stock options to their employees at a low price.

But why don’t the valuation professionals undervalue the company?

Well, there are many reasons for this:

  • There is a risk where the IRS can take action, which would also affect the client negatively.
  • The firm being valued at a low price would be at risk with the IRS.
  • Valuation professionals agree to the professional ethics that prevent them from doing this.

Due to this, most valuation professionals try to give the valuation at the low-end of the defensible range. Just to help you understand better, defensibility refers to the likelihood that a 409A valuation can easily withstand an IRS audit. So the more defensible the valuation, the safer it is from an audit.

To learn more about the 409A valuation, check out the article here!

Venture Capital (VC) Valuation & It’s Methods

VC valuations take place when a VC purchases the shares in a private company in exchange for their investment. Now let us say that a VC firm purchases 1,000,000 shares for $5 million from your company. This means that they paid $5.00/share. As per the Venture Capitalists (VCs), the value of the company is the price per share that they paid, multiplied by the outstanding shares of the company.

This means that if there are 5,000,000 shares after the VC invests in the company including the 1 million that the VC owns, the company would have a worth of $25 million. And since the VCs have fancy words for their valuation, they call the $25 million as the post-money valuation of the company. It is called post-money as it represents the value of the company after the $5 million investment was made.

To explain better, let us say that you start a company named ABC worth $20 million. Now, you get an investment from an outside VC firm of $5 million. So, how much would the worth of ABC be now? Well, since we are assuming that nothing has changed(except for the investment added), it makes sense that the company would have a value of $25 million.

VCs call the value of the company before their investment as the pre-money valuation. So, in the example shared above, the pre-money valuation of the company was $20 million and its post-money valuation is $25 million. As a matter of fact, the pre-money and post-money math are very easy.

You just need to remember a few formulas as shared below:

  • Post-Money Valuation (version 1) = Total Company Shares * Price Per Share the VC Paid
  • Investment = Price Per Share the VC Paid * Number of Shares the VC Bought
  • Pre-Money Valuation = Post-Money Valuation – Investment
  • 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

With this clear, you now know a little more VC terminology. But how do VCs actually figure out that the given valuation is the one that they are ready to give the startup? That is where things become complicated. And with this, the Venture Capital Method comes into play.

The VCM (Venture Capital Method) is a very useful valuation method that is used to obtain the pre-money valuation of the company. If your company has not yet earned any revenue yet, the VCM is well suited for your company. The pre-money valuation can be easily calculated to reflect the view of the investor. The VC would also be searching for a high exit to reward him or her for the risk that they have taken while investing in the startup.

Kindly note that calculating the valuation with the venture capital method involves a lot of assumptions. There is not one true valuation method.There are a lot of assumptions involved that open a space of flexibility. And since you are the founder of the company, it is vital that you understand all the basics of it. This will allow you to understand what is happening and discuss the various different scenarios and assumptions with your investors.

409A Valuations Vs Venture Valuation

Now that you are clear about what the venture capital valuation and the 409A valuation are, why are they different when both give the value of the company at a given time? For starters, the 409A valuation is usually lower than VC valuations.

The VC valuations are also not designed to hold up under IRS scrutiny. A Venture capital valuation is market-driven, which is a great point, but they have many other problems in it. VCs arrive at the valuation using their gut instinct. And the math involved in the VC model violates a few of the core valuation principles, as mentioned before.

Furthermore, the VC method assumes that all the shares in the company are of the same value. For instance, the VC model considers the Series D shares and the common stock are worth the same. In reality these are not the same, as the common stock have the following advantages that the Series D shares don’t:

  • Board rights
  • Superior voting rights
  • Potential liquidation preferences
  • Rights of drag-along, co-sale, and so on

On the other hand, 409A valuations are very different. They offer an IRS-defensible valuation of the company. But keep in mind that these valuations would generally be at the low end of an acceptable range.

Also in general, a 409a valuation would not affect the computation of a VC valuation. This is because VCs understand that the 409A valuations are compliance-focused and will be at the low-end of an acceptable range. In fact, VCs often do not trust a 409A valuation firm to tell them the true value of a company. The VCs feel that valuing a company is a core competency. and the implications of valuation decisions have massive impacts on their business. So, they won’t trust a 3rd party with this decision.

In short, both of them are very different from each other in every way possible.

Conclusion

So next time you encounter an investor who wants to value your business on their own and gets a different value from what you got for the 409A valuation, you would know why it happens. And while you make a deal with the VC for your company, remember to keep track of the shares in your company using a cap table. Eqvista can help you with it.

It is a FREE web application that allows you to keep track and manage the shares of your company with ease. It also assists in keeping your company compliant with various equity-related rules.

Interested in issuing & managing shares?

If you want to start issuing and managing shares, Try out our Eqvista App, it is free and all online!