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. This 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 or investor 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 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

Post Money Investment Valuation and 409a Valuation

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 sides have the same information about the asset. There is no compulsion for either of the parties 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 valuation 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?

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.

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 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.

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.

What is a Post Money Investment Valuation?

The post-money investment valuation, also called VC valuation (or investor valuation), 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.

Valuation Method – Exit Multiple

• When estimating a company’s cash flows in the future, analysts use financial models such as the discounted cash flow (DCF) to arrive at the value of the business.
• The method comprises two components: forecast period and terminal value. The forecast period estimates a company’s value for three to five years and terminal value solves uncertainty.
• The two approaches to calculate terminal values: Exit Multiple and Perpetual Growth method.
• The exit multiple (EV/EBIT or EV/EBITDA obtained from comparable companies that were recently acquired) is multiplied by EBIT or EBITDA in the final year of the projection period to give the terminal value at the end of the year.
• The terminal value is then discounted using a company’s Weighted Average Cost of Capital (WACC) and added to the present value of the free cash flows to obtain the value of the business.

Example

So, let us say that a company has an EBITDA of $2.55M in the final year of the projection period.

• The exit multiple is obtained from comparable companies that were recently acquired to calculate the terminal value.

• The terminal value is calculated as shown below:

• The terminal value is then discounted using a company’s Weighted Average Cost of Capital (25%) and added to the present value of the free cash flows.

• So, in the above example, the value of the business is $19.05M.

Pre-Money Valuation

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 and a 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.

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.

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.

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.

Example Of Common and Preferred Stock

Tech Corp is a software company delivering products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience.

Here is a look at how their simple cap table looks after issuing common shares.

For preferred stock, they usually have a lot more shareholder rights than common shares. So when they are added to your cap table, you need to track things like conversion rates, liquidation preferences, participation rights and if there are any dividends.

Here is a look at how their simple cap table looks after issuing preferred shares.

Main Differences Between Common & Preferred Stock

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

Why Companies Issue Common Stock and Preferred Stock ?

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 judgment and experience of the analyst more than the observable market evidence.

With a better idea of 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.

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Making Informed Decisions for Your Business With Eqvista!

Post-money valuation and 409A valuation are two different types of valuations used for other purposes. Post-money valuation is used by investors to determine a company’s worth and raise funds. In contrast, a 409A valuation is used to determine the fair market value (FMV) of common stock for tax purposes related to stock-based compensation.

However, it’s important to note that these valuations are calculated using different methodologies, which can lead to disparities in the results. To ensure accurate and timely valuation, it’s crucial to analyze all the factors involved and seek expert guidance closely. At Eqvista, we provide top-notch valuation services and are always ready to assist you in any way possible. Feel free to contact us to learn more about our services.