Valuation comes up constantly in reference to startups. But it can be confusing because sometimes the same word is used with very different meanings.

Several different types of valuations come into play for startups. For example, there are the staggering and not necessarily realizable private company valuations that everyone hears about. There are public market valuations that reflect what investors believe stocks will be worth in the future. And there are 409A valuations.

Key differences between business valuations and startup valuations.

Business valuations: the price of the company Startup valuations: what someone 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 Comparable transactions
Investor sentiment 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

409A valuations

Some of the same factors that drive other types of valuations also come into play for 409A valuations. But there are also some big differences. 409A valuations were introduced as part of the Sarbanes-Oxley legislation that followed the 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?

  • Company milestones
  • IP
  • 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 stay in compliance with the requirements on his or her own. What’s more, if you plan on selling your business or raising funding, potential investors and acquirers will also scrutinize your 409a valuation as part of their due diligence. Rather than getting yourself tied up in knots, or worse, winding up on the wrong side of the eight ball, hire a qualified professional who can guide you through the process.

 

Guest blogger David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.

Do you have more questions on valuation or need assistance in determining your 409a valuation? Contact Early Growth Financial Services for a free 30-minute consultation!