Valuation comes up constantly in reference to startups. But it can be confusing because it can actually different meanings and implications depending on the context.
There are several different types of startup valuations:
There are the staggering and not necessarily realizable private company valuations that people often hear about;
There are public market valuations that reflect what investors believe stocks will be worth in the future; and
There are 409A valuations.
Differences Between Public Business Valuations and Private Startup Valuations
Business Valuations: The market price of the company
Startup Valuations: What a private investor is willing to pay
Cash flows (now and in the future)
The size of the opportunity—as measured by the market growth rate
Asset values (physical and intangible)
Your team’s credentials
Demand from potential buyers
Market sentiment for your sector
Traction—number of users, repeat visits, subscriptions, and/or other metrics
Your capital spending plans
Option pool—the larger it is, the lower your valuation
Participation preferences on preferred stock
Some of the same factors that drive other types of valuations also come into play for 409A valuations. But there are also big differences.
409A valuations were introduced as part of the Sarbanes-Oxley legislation that followed the 2008 financial crisis. The government’s goal was to ensure that federal income taxes are paid on stock issued as part of deferred compensation plans.
What impacts a company’s 409A valuation?
The industry’s competitive dynamics
Your business partnerships
Your capital structure
Your management team’s credentials
409A valuations and companies benefit from a “safe harbor” provision that a valuation “reflects the fair market value (FMV) of the stock…” They should be deemed valid if “the valuation is based upon an independent appraisal, … by a qualified individual or individuals…”
In determining FMV, The IRS deems “…relevant factors prescribed for valuations…” such as:
fair market value (FMV) — “determined by … a reasonable valuation method.”
“…evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.”
Recent equity sales; i.e., comparables.
The IRS also stipulates that valuations be performed by “a qualified individual” with “significant knowledge and experience or training in performing similar valuations.”
What counts as significant? For the IRS, it means “at least five years of relevant experience.”
Clearly 409A valuations impose high standards—and the average founder is unlikely to have the experience to meet the compliance requirements with help from a third party.
What’s more, if you plan on selling your business or raising funding, your 409a valuation will be scrutinized as part of the due diligence process.