409a Valuation & how it works for your business

 

There’s an art to forecasting a business’ future. And the stakes for making accurate projections are high. Potential partners, staff, investors, shareholders, and insurance carriers want to make sure the one tasked to determine the value and financial potential of the startup makes a correct assessment. That’s where the 409a valuation comes into play.

Many variables contribute to a business, or a person, becoming successful; and critical indicators may not always be apparent.

For example, consider this true scenario: It’s the late 1700’s and a family of six is in poor health. The father has syphilis, and his wife has tuberculosis. They had five children, but one died as a young child. At present, three children are gravely ill, and the wife, though sick, just gave birth. What would you rate the likelihood of the newborn surviving to adulthood? And if you knew that the newborn would live to age 57, but would start going deaf before age 30, would you bet that person would make many significant contributions to society? Most would not, but he did. The man who died deaf was Ludwig van Beethoven.

Good valuation experts observe seen and unseen variables to properly assess the current and potential value of a business. This article profiles some of the variables associated with valuating a startup business.

Startups are the seedlings of the business world. They are grown in nurseries called accelerators or incubators. Determining the health and potential harvest of a seedling (a startup business) is accomplished through a 409a evaluation.

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Rules regarding valuations and how private companies can issue stock shares to employees changed in 2005.

In 2005, the IRS began requiring businesses intending to issue stock options to acquire a professional valuation. The government established the new guidelines to ensure proper accounting of non-cash components of employee compensation —, particularly stock options. In short, the IRS wanted to know how much individuals could be taxed, and the government determined that valuating startups (businesses issuing stock options) were key to making that determination.

What makes the process of evaluating a startup particularly difficult is that the typical markers for determining value (revenue history, established profit margins, name recognition, or inventory levels, etc.) may not yet be available. However, these new businesses need clout to attract investors and employees. A new company can compensate for a lack of business history via a  strong valuation report.

As startups do not have the traditional matrix valuation experts used to assess a company, they have formulated innovative ways to determine value. Three primary approaches are noted below:

 

1. If there is revenue and cash flow history, a more traditional approach can be used to evaluate the business—such as a market approach or discounted cash flow. A market approach analysis uses comps, or value assessments of similar companies, to establish a value. A Discounted Cash Flow (DCF) approach determines the value of a business by projecting current revenue figures into the future and factoring that information into an assessed value.98% of startups take time to establish momentum and post profit data. It is therefore often necessary to use the revenue matrix in a market approach to properly value new businesses. In this scenario, if a company’s revenue is 5 million, and peer or comparable companies are trading at 8x, then the company’s value could be $40 million.
2. A company is worth whatever someone is willing to pay. Think eBay—the true value of your item may not be the buy now price but rather, the winning bid price. With this in mind, one valuation method is to assess a value based on the company’s last round of funding. This valuation method is acceptable if the numbers in question are current. As long as a round of funding took place within the last six months, and there have been no significant changes in the business or market, it can be argued that a value based on the last round of funding is an accurate benchmark for the company.
3. Suppose a company does not have revenue or has never raised capital: In that case, valuing it is similar to valuing an art collection by an unknown artist, who has never sold anything. The artist, like the founder, is an unknown without a track record. This type of business is generally not attractive to venture capitalists, who can have rigid investment stipulations. Therefore, looking to them for information on the profitability and value of comparable businesses is generally not a viable option. However, “Angel Investors,” who often offer flexible investment terms and have more altruistic interests, may be able to provide stats on profitability and value as they are better positioned to have had contact with businesses early in their revenue-generating curve. Valuing a company can therefore be accomplished by showcasing a business to an “Angel Investor” to gather comparables data, and, augmenting that information with stats from PitchBook and other databases to create a virtual marketplace to support a valuation conclusion. 

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Part Two in the 409a Valuating Process

Assigning a total value for a business is only the halfway point in the valuation process.

Once a value is assigned to the entire business, an evaluation expert must allocate that value into different classes of Stock, because each class of Stock has different terms, conditions, and ownership rights. This is similar to crude oil having a base value but can acquire different values as it is refined into different products to cater to different demands.

Determining the value of a company is fairly straightforward compared to allocating that value into different classes of Stock. A seasoned valuation expert knows that the allocation piece noted above is the Achilles heel in a 409a valuation.

In the broadest sense, there are two classes of Stock, each having subcategories within those classes. The two primary categories are Preferred Stock and Common Stock.

Preferred Stock provides the holder with a fixed dividend schedule (when there is profitability), and a first-in-line payout status should the company be liquidated.

Common Stock is, not surprisingly, the most common. This Stock option provides the holder with a voting right (typically, one share translates to one vote), freedom to sell the Stock at will, and an undefined dividend expectation (the profitability of the business determines the number of dividend payouts).

A proper valuation of your business can have far-reaching legal and financial ramifications. Successful entrepreneurs excel at doing the right things on the front end to maximize potential on the back end. Working with a strong evaluation expert can help startups get to where they want to go.

As Mark Twain said, “Get your facts straight first, and then you can distort them as you please.”