How Do Private Companies Value the Equity of Their Stock
For Publicly traded companies, there are many levers to calculate the value of the stock. It's also quite easy to do baseline the stock price compared to other companies in the industry. The financials are also reported and in many cases available for public consumption.
On the other had, for Private companies, usually offer equity stake (though stocks) in the company, to raise capital and attract talent to the company. Since, the company is private, or a startup, to value the stock is more of an art than a science. This is where IRS Section 409A valuation comes into the picture.
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What is a 409A valuation and Who can perform this?
The story dates back to the Enron scandal, when in 2001 regulators looked for ways to plug the loopholes used by Enron executives. As a result, IRS introduced Section 409A in 2005, finalizing it by 2009.
Section 409A is a framework for private companies to adhere to, when valuing private stock. The key tenant is that valuation is conducted by an unaffiliated or independent party. This practice establishes a safe harbor, meaning the 409A valuation is presumed to be “reasonable” by the IRS.
IRS provides three safe harbor methods for setting the Fair-Market-Value (FMV) of private company common shares:
- Independent appraisal presumption
- Binding formula presumption
- Illiquid startup presumption
The most common approach to achieving 409A safe harbor status is using a qualified, third-party appraiser The cost for 409A valuations can range anywhere from $1,000 to over $10,000, depending on the size and complexity of the company.
When should 409A Valuations be Triggered?
A 409A Valuation needs to be done prior to startup offering equity stake in the company. IRC 409A valuations are valid for a maximum of 12 months or until a “material event” occurs.
For startups, an initial financing is the most common material event. Other material events could be acquisitions, divestitures, secondary sales of common stock, business model pivots, and missing or exceeding financial projections. In essence a 409A valuation should be done:
- Before issuing first common stock options
- After raising a round of venture financing
- Once every 12 months (or after a material event)
- When approaching an IPO, merger, or acquisition
What are 3 most common 409A methodologies?
There are three standard methodologies used by Independent appraisers to obtain the FMV.
1) Market approach (OPM backsolve)
Market based approach uses financial information like revenue, net income, and EBITDA from comparable public companies to estimate the company’s equity value.
For new startups, when initial round of financing is raised, investors usually get preferred stock and employees common stock. This creates different classes of security. To address this complexity, Option based valuation method (OPM backsolve) is used. The principle that the OPM backsolve method is based on is that an economic relationship exists between the various classes of securities. Therefore, when the value of a single class of equity is known, this method provides the ability to determine the value for all other equity-related securities.
2) Income approach
This approach is used for businesses with sufficient revenue and positive cash flow. This method defines company’s FMV as its total assets minus its corresponding liabilities.
3) Asset approach
The approach is used for early-stage startups that have yet to raise capital and do not generate revenue. This methodology calculates a company’s net asset value to determine a proper valuation.
Key Takeaways:
For startups that are looking into raising capital or getting ready for a material event to transpire, should engage with reputable third-party firms to perform 409A valuations.
In the larger scheme of things, this will ensure that startup is less likely to be audited and penalized by IRS and no penalties are incurred by stakeholders.
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