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? While it may not be common knowledge, both Venture Capital 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, Venture Capital valuation 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.

Basics of 409a Valuation

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 parties 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:

#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.

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

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.

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.

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 is 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:

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 know more 409a valuation methods and the venture capital valuation method.

Understanding the Purpose 409 Valuation and Methods

The purpose of a 409A valuation is to establish the fair market value (FMV) of a private company’s common stock.  The IRS requires it before a private company can issue stock options or equity compensation to employees, consultants, or other service providers.

A 409A valuation enables private companies to issue stock options at a fair and compliant price, protecting the company and its employees from potential IRS penalties related to undervalued equity compensation.

A 409A valuation serves the following key purposes:

• The strike price for stock options: The fair market value (FMV) determined by the 409A valuation sets the exercise price (strike price) for stock options granted to employees. This ensures options are not issued below FMV, which could trigger tax penalties.
• Protect employees from tax liabilities: Issuing stock options below FMV can require employees to immediately recognize the difference between the FMV and the strike price as income. This, in turn, can lead to potential 20% penalty taxes upon exercising those options. A proper 409A valuation can prevent such scenarios and protect employees from these adverse tax consequences.
• Equity compensation: By establishing FMV through a 409A valuation, companies can offer stock options and other equity incentives to employees on a tax-advantaged basis, aiding in recruitment and retention. This approach not only ensures compliance but also presents a positive opportunity for companies and employees.
• Compliance with IRS regulations: Section 409A of the Internal Revenue Code requires companies to price stock options at or above FMV to avoid adverse tax consequences for option holders. A qualified 409A valuation provides a defensible, independent valuation that meets IRS safe harbor requirements.

Failing to comply with 409A valuation requirements exposes the company and its employees to significant financial, legal, and reputational risks. Obtaining a timely and qualified independent valuation is crucial to avoiding these adverse consequences.

409a Valuation Methods

• 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.

Understanding 409A Valuations Methods Compared

Based on the 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.

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 Valuation

Valuation is critical to VCs to determine their ownership stake and potential return on investment. But the methodologies can vary significantly according to firms, leading to different valuations for the same firm.

Case study for venture capital valuation

Tech AI is a fast-rising cloud storage startup known for its AI-powered data security solutions.  After developing their products, they were able to secure funding from venture capitalists to expand their market.

The company then decided to take on its initial investment from a venture capitalist. The total amount of the investment was $5 million to support the company to develop its product and expand its market. With this investment, the price per share paid by the venture capitalist was $5.00 per share.

The company’s value increases to $25 million after receiving funding from venture capitalists.

This example shows that with a $5 million investment, the pre-money valuation is $20 million, and the post-money valuation is $25 million.

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

Venture Capital  Valuation Methods

The Venture Capital valuation Method 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. 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.

Here are the key  valuation methods used commonly used by venture capitalists:

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

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.

409A valuations and venture capital valuations serve different purposes and use distinct methodologies, resulting in valuation differences for the same company. 

Detailed Overview –  409a Valuations vs Venture Capital Valuation

In summary, 409A valuations provide an objective, point-in-time FMV assessment for compliance. In contrast, Venture Capital valuations are forward-looking estimates negotiated between investors and founders based on the company’s future potential. As such, the two valuations can differ significantly for the same company.

Simplify Your Startup’s Valuation With Eqvista!

The Venture Capital valuation method is widely used to value startups and high-growth companies, especially those that have yet to be profitable or have a limited operating history.

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 your venture capital valuation.

Eqvista’s 409A valuations are audit-ready and designed to protect companies from IRS penalties. Their comprehensive offering and competitive pricing make them compelling for startups seeking 409A valuation services. Our 409A valuation pricing starts at $990 per year for startups, with higher tiers for larger companies.