Post Money Investment Valuation vs 409A valuation

For companies looking for more funding to expand, the difference between a good and bad funding round is in the details of the company valuation. These funding round brings with it an entirely new set of terms and vocabulary to get accustomed to. In short, you probably would hear the terms “409A valuation” and “post money investment valuation”, mostly when you are giving out shares of your company.

Introduction

So, what is the difference between the 409A valuation and the post-money valuation (also called VC valuation)? The 409A valuation is performed by compliance experts and is the estimate at the low-end of a defensible valuation range. On the other hand, the post valuation is the market value negotiated between entrepreneurs (you) and the venture capitalists (VCs) offering investment. The post-money valuation and the 409A valuation can be performed at the same time, but give out a different values for each.

To understand this better, we would have to understand the basic theory of valuation of a company.

The professional valuators consider the value of an asset as its fair market value, and the IRS represents the fair market value as the price at which the property would be sold for in the open market. Basically, it is the price at which the buyer and the seller have agreed on, with neither of them required to act, both with a reasonable understanding of the pertinent facts.

From this, we can derive three things:

• The valuation is the transaction price between the seller and the buyer (which is compared by the previous sales of similar assets in the market based on comparability, frequency, and certainty)
• There cannot be any necessity to sell or buy for the parties
• Both parties must have proper information

Valuing Companies

It is relatively easy to value a company on the open market, as almost everyday investors purchase and sell thousands of small percentages (the stock) of the company. As they are based on the FMV, they are fair transactions and both the sides have the same information about the asset. There is no compulsion for either of the party to sell or buy the asset, also meaning that they represent accurate prices.

In case you know the exact value of a part of the pie, it is very simple to use math and deduce the value of the entire pie. For instance, if you bought 1% of Infosys for $50M, then you know that the complete organization is worth approximately $5 billion. Although the actual valuing is more complicated than this, this is for you to get a simple idea for the difference between the 409A valuation and the post money investment valuation.

Currently, there are many methods that help in the valuation of a private company.
However, the 3 most commonly accepted approaches are:

• Market approach: Determining the value of the company by comparing it with the value of similar companies.
• Income approach: Getting the value of the company by analyzing the total value of its future cash flows.
• Cost/asset approach: Find the company value by adding all the costs of its assets or rebuilding the company.

The professionals who conduct the 409A valuation use these methods, along with other complicated financial modeling, to find the value of these private companies. On the other hand, VCs get the post money investment valuation of a company using their gut feeling, experience, and the venture capital method (also called the First Chicago Method).

Now that you have an idea on how valuations are done and what they are all about, let us understand the two in more detail.

What is a 409A Valuation?

It was recently in the 2000s when the US government established regulations regarding common stock options. Due to this, a new section was created in the Internal Revenue Code called the IRC 409A. 409A valuation was established to make it costly for any company to issue stocks below the FMV (fair market value).

But the regulators did not want this to negatively influence startups a lot, allowing them to easily issue shares. Hence, they created a hatch for the startups. Now, startups can pay a moderate price for having their 409A valuation done by an independent valuation firm. With this done, the startups can easily qualify for the safe harbor status, eliminating any 409A risks.

409A valuations are needed when a company is about to issue shares to their employees or for raising capital. If the company decides to estimate a value of the shares before issuing, they may fall in trouble with the IRS, as per the IRC 409A. They could pay heavy fines for miscalculating the share value.This is the main reason why 409A valuation is important for a company who is about to issue shares.

Note: This article just gives a brief on 409A valuation and is more about the difference of it as compared to the post money investment valuation. To learn more about the 409A valuation, check out our previous guide on it here.

Moving ahead, let us talk about the methods that these 409A valuation professionals use. Some of the most common approaches that they use are:

• Discounted Cash Flow Analysis: The projected cash flow is used to get the valuation.
• Asset / Cost-to-Recreate Approach: The cost of buying similar assets like those in the company or the value of the assets of the company is used to get the valuation.
• M&A (or Transaction) Comparables Analysis: The transaction acquisitions of the other businesses are used to get the valuation.
• Public Comparables Analysis: In this method, similar public companies are used to get the valuation.
• Backsolve Option Pricing Model: The recent sales of the preferred stock are used to have the valuation done for the company.

The person or firm working to get the company’s 409A valuation selects the most reliable approach for the value of the company. They may also use the weighted average between different methods.

As mentioned above, the IRS needs you to have the 409A valuation done to establish the point estimate of the value of common stock. A point estimate means a single number approximation of the value as compared to a range of values. Hence, the professional performing the valuation picks the point estimate that is close to the low end of the defensible range of values. This is done as companies usually want a lower valuation as it becomes easy for them to offer stock options to their employees at a much lower price.

Now if the companies want a low valuation result, then why don’t 409A professionals simply not make a low value? Well, as mentioned before, keeping a lower value of the company would put the 409A valuation professional in trouble with the IRS. The company too would fall in trouble with their employees, who would suffer from large taxes on their undervalued shares. This is the reason why professionals pick a 409A valuation toward the low-end of a defensible range to make peace with both the company and the IRS.

Now that you have a better idea regarding about the 409A valuation, let us move to the second part about post money investment valuations.

What is a Post Money Investment Valuation?

The post money investment valuation, also called VC valuations, comes from the actual transactions of when a venture capitalist purchases the shares of a private company. This happens when they are investing in the company, and take equity in return for the investment.

So, let us say that the company has 5 million shares, and the VC got 1 million shares , the company would have a worth of $50M. This number, $50M, is called the post money investment valuation. The reason it is called post money is because the value of the company became this after the $10M investment.

And this method makes a lot of sense. For instance, let us take a company named NettyAB with a worth of around $40M at the moment the company is negotiating a deal with a VC firm. Within 5 minutes of the deal being confirmed, the company would have $10M more. With nothing extra changing in the company, it would now have the worth of $50M. In short, its worth was $40M about 5 minutes ago, plus now $10M more in cash.

The value of the company before the investment is called the pre-money valuation. So, in the above example, NettyAB’s pre-money valuation is $40M and post money investment valuation is $50M, which is easy to understand.

Here are a few simple formulas to remember for post money investment valuations:

• Post Money Investment Valuation (1st) = Total Shares in the Company * Price Per Share the VC Paid
• Investment = Number of Shares the VC Bought * Price Per Share the VC Paid
• Pre-Money Valuation = Post Money Valuation – Investment
• Post-Money Valuation (2nd) = Pre-Money Valuation + Investment
• Post Money Investment Valuation (3rd & Final) = Total Number of Shares Outstanding after the Round * Price Per Share the VC Paid

With these formulas, we can easily understand the vocabulary of a VC. The post money investment valuation is usually higher than the 409A valuation, as the valuation professionals find the value towards the lower end of the acceptable range, and VCs don’t.

Before we move ahead, there are two other terms that you need to be aware of to understand the difference between the post money investment valuation and the 409A valuation; common stock and preferred stock. Let us understand them first.

What is Common Stock?

Common stock are the shares that the owner and shareholders own of the company. The shareholders have to take both the rewards and the risks of the ownership, but the involvement by these shareholders are bounded by the amount of capital they contribute. Basically, a publicly traded company issues common stocks for raising capital at the price that the market is ready to pay.

As a matter of fact, the value of the investment of these stocks can increase, thereby establishing the the worth of the company. This happens because of the reinvestment of undistributed earnings. To understand the rights of common shareholders, some points are as below:

• Right to Vote: During the general meeting, the shareholders have the right to elect the board of directors of the firm and vote on many other corporate policies.
• Right to Income: They have the rights to get a continuous earning of the company.
• Pre-emptive Right: This means that they are allowed to purchase the stock of the company before the shares are publicly available, to maintain their proportional ownership in the company.
• Right in Liquidation: The shareholders have the rights to get the remaining assets and amount of the company during any liquidation event. This is only when all the debenture holders, creditors, and preferred shareholders are paid off. Then, the assets and amount remain are distributed to the common shareholders, as per their percentage of ownership in the business.

Now that you have an idea about the common stock, let us understand what the preferred stock is.

What is Preferred Stock?

Preferred stock is one class of the company’s securities that do not carry any rights for voting. But this kind of stock has a much higher claim on the income and assets of the company. These shareholders enjoy preference in specific matters, such as the payment of a dividend of a fixed amount and the repayment of any fund during the company’s bankruptcy or liquidation. In short, it is a fixed income-bearing investment that might or might not have any maturity period.

The nature of these dividends can be cumulative, where the payments may accrue over several years, and paid out to the shareholder at one time. If payment of the dividends isn’t made continuously for three years, then the shareholders would automatically gain the rights to vote in the next general meeting.

Main Differences Between Common & Preferred Stock

Now to understand what makes them different from the following points:

• Common stock is issued normally to raise capital in the company, where voting rights and ownership rights are offered. Preferred stock gets more priority based on the repayment of capital and payment of dividends.
• Common stock has great growth potential while preferred stock’s growth ability is lower.
• The return on capital for common shareholders is not guaranteed and nor is the amount fixed. Preferred shareholders often have a fixed rate and return is guaranteed.
• A common stock has different rights for repayment of capital, dividend, and voting, while preferred stock has rights to dividends and capital repayment.
• A common shareholder can vote and participate in the general meetings of the company. On the other hand, preferred stock usually do not have these rights.
• Common stock cannot be converted into other security, while preferred stock can be converted to debt or common stock.
• Common shareholders do not have the rights to get the arrear of dividends from previous years. On the other hand, preferred stockholders have the rights to gain the arrears of dividend from these years.

Why Companies Issue Them

Now that you know their differences, let us understand why they are issued and what is the benefit of having both types. To begin with, preferred stock is used to raise funds for the company to grow.

The companies utilize preferred stocks to give corporate ownership to another company. Companies who offer preferred stocks get a tax write-off on the income of dividends. In short, they do not need to pay tax on the initial 70% of the income they get from the dividends, depending on their percentage of ownership. On the other hand, individual investors do not enjoy a similar tax advantage.

Moreover, it is easy for companies to sell preferred stocks faster than the common stocks. This is because owners know that they would have preference over the common shareholders. Preferred stocks are also much more expensive than bonds, where the dividends paid by preferred stocks comes from the after-tax profits of the company.

Due to these, the valuation of the common stock is simpler to find and is usually lower than the preferred stock. The value of the preferred stock usually lacks any of the kicker that the common equity has, like the convertibility or any other special features. This makes the value of the preferred stock equal to the present value of its future income stream discounted at its required yield of rate of return. In short, the greater the investment risk, the greater the required yield.

Due to the flexibility in the characteristics of the preferred stock, the capability of getting the estimated value of the preferred stock usually depends on the subjective judgement and experience of the analyst more than the observable market evidence.

With a better idea in what common stock and preferred stock are, you need to know that 409A valuations consider preferred stock to have the same value as the common stock, which is why the value taken is a lower value. On the other hand, for the post money investment valuation, the value of the common stock and preferred stock are considered to be much different. Let us get deeper into the difference between the two valuation types.

Summary of Post Money Investment Valuations & 409A Valuations

By now, you have a clearer idea about the two kinds of stocks that help in these valuations. Both of these are valuation methods and are used in different cases.

The post money valuation is figured out based on the pre-money valuation derived by VCs using the methods to get the value of the company. This helps the VCs know how much to invest in the company, and used to negotiate when a company is looking for investments. On the other hand, the 409A valuation is performed to the rules placed by the IRS in the 2000s. This is done to stay in-line with the IRC 409A, so that the company doesn’t issue shares at a low rate.

Difference in Calculations

Other than the final value of the post money and 409A valuation, the calculation methods also differ in both the cases. The post-money valuation is simple as they use the value of the common stock and the preferred stock. On the contrary, as per the regulations that govern the IRC 409A / ASC 718 valuation reports, the 409A valuation has to be determined using more complex methods, where it treats both the preferred stock and common stock differently. And the reason as to why they treat them differently is because they have different values entirely.

So, ask yourself – which one of these stocks would you like to own or which one of these would a VC investor pay more to buy. Preferred stock, right? It is the obvious choice as preferred stock has many liquidation preferences, the potential to withhold the approval of any new shares or series of capital stock, and the power to block any sales or financings. On the other hand, common stock doesn’t have these advantages (other than the normal rights), which makes it less valuable.

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Conclusion

So, the next time you encounter an investor who wants to value your business and gets a different value from you, you may now understand the difference in your calculations.

409A valuations are designed to value the company with a lower valuation, more for the purposes of issuing and transferring shares, as per IRS standards. It offers an IRS-defensible valuation of a company. However, the post money valuation is derived by the gut-instinct of the VCs. Post money valuations have not been designed to handle the IRS scrutiny, and they use different methods and core valuations principles. It is clear that the two valuation methods are not the same thing and are not used for the same purposes.

With all the dealings that you are about to make with potential VCs, don’t forget to keep a record of the shares you are giving out. For that, you would need a cap table. Eqvista is a 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.