This post was contributed to VentureApp by Dan Eyman, managing director and founder of Meld Valuation, a San Francisco-based firm that provides 409a valuation services tailored to the startup and venture community.
As you know, obtaining a 409A valuation is important if you are a private company and plan on giving equity to your employees because it formally informs you and others of common stock value. But, when it comes to private company 409A valuation, it’s helpful to first have some further context. 409A valuations are not the value of your company or the pre-money valuation that you use to raise a round. 409A valuations are a tax compliance issue.
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When we think about valuation, we think in terms of a continuum – at one end is the exit that you are dreaming of and will make you rich and the other end is a possible liquidation value. What would the assets of your company sell for if you had to shutdown? It could be as low as zero. At any one point in time a company can have a wide-ranging value spectrum depending on motivations, purpose of the valuation, information asymmetry, and more.
Still unsure whether you need a 409A? You can learn more here before deciding. If you know you need a 409A, we recommend keeping the following factors in mind to make the biggest impact on your valuation.
Include Planned Option Grants in the 409A Valuation
Include planned option grants for the coming year, even if it is an estimate. Companies often don’t include this or think it is relevant to the 409a valuation – and often the valuation firm does not think to ask about it. It’s recommended to include the options in the 409a valuation of a venture backed company when using an option pricing model. Including these planned grants can draw value away from the common stock. The mathematical explanation of why is beyond the scope of this article but it does help a little bit.
Make Sure Your Cash Runway is Reflected
There are several defensible ways to make sure this is accounted for in a 409A valuation. It’s typically recommended to take cash runway into account when considering the time to exit, which is an input into the option pricing model. Not every valuation firm will do this, or know how to do this – it’s important to ask up front.
Establish that Volatility is Reflective of a Startup
Volatility is an input into the option pricing model which is used in most venture backed 409a valuations. Statistically, higher volatility is negatively correlated with size of a company. This makes sense – more diversified and stable companies will be less volatile in their performance (think blue chip versus micro-cap stocks). The mathematical relationship between the volatility and your common stock price is not straightforward but ask your valuation firm to play around with the input to optimize it.
Typically, smaller companies have higher volatility which results in a higher value from an option pricing model. But the same volatility (or roughly the same) will be used to calculate a marketability discount which will also result in a higher discount to the common stock. So, it appears they offset each other but it is a little more complicated than that – your valuation analyst should optimize it.
Use Conservative Financial Projections
I think this is self-explanatory. The more optimistic the projections, the higher the valuation. Keep in mind that a valuation firm should also be looking at expenses, as well. If the firm is utilizing a discounted cash flow approach I would ask about to weight this approach as little as possible as we all know that startup projects are not entirely reliable.
Ask About the Discount For Lack of Marketability
This is a discount that is taken as there is no active and liquid market to sell your startup’s common share. Most valuation professionals will apply a wide range for this discount. How aggressive a discount for lack of marketability (DLOM) is applied in a 409A depends on the stage of your company, who your auditor is , and how well the valuation firm your dealing with can defend their selection. Firms less experienced with early stage startups tend to come in too low or too high. Always question the range and whether they can be more aggressive. Either way, make the case regarding just how unmarketable your shares are to increase the discount and drive the common stock value lower.
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