How a 409a valuation works?

Could you predict if a 4-year-old will be successful? Or if a rookie soccer player will play for the national team? Or if a newly married couple will stay together forever?

I can’t. But part of my job is to conclude if a startup will be the next billion-dollar company.

Startups are the seedlings of the business world. They are grown in nurseries called accelerators, or incubators, or angel funds. How would one go about knowing a seedling’s future health, size, or harvest?

What if assessing this seedling’s future was the law? What if people’s livelihoods depended on getting this right? What if done incorrectly, this miscalculation could cost billions to shareholders in IRS penalties?

Ever wondered how EBITDA affects your companies value? Learn More.

Let’s see how a 409a valuation works…

IRC 409a was implemented in 2005. The IRS wanted to ensure they take their fair share of taxes of the non-cash piece of employee compensation from Silicon Valley companies. However, before 2005, companies were giving employees stock options while not being on the hook for paying taxes.

I mean, think about it. Startups never have a profit, and they are lucky if they have revenue or a product. Yet, they need to attract customers, investors, and employees. How?

They use a currency called ‘Valuations.’

Startups do not have the traditional metrics valuation experts use for valuing a company. So either we literally make up numbers, and call it a valuation, or reinvent new formulas to value startups. Valuation experts, after prolonged deliberation, have created innovative ways of quantifying the values of such startups.

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There are 3 ways to value a startup –

1. Assuming the company has revenue or cash flow metrics, then we use discounted cash flow method or market
   approach. The traditional methods of valuations. However, since 98% of startups are not profitable, a revenue-based market approach is most likely to be used.

   For example,

   if a company has $5M in revenue, and comparable companies are selling/trading for 8x on revenue, then the company’s value can be $40M.

2. A company is worth whatever someone is willing to pay for it. This valuation method is based on the company’s last round of funding. So if someone paid $20M for the last round of funding, so long as that round is within 6 months, we can argue that that valuation is the best benchmark.
3. If the company does not have revenue or has not raised capital, then valuing it is similar to valuing an art collection from an unknown artist who has never sold anything.

The artist like the founder is unknown without a track record. The art collection without a following or history of transactions is like the company without revenue or history of capital raise. So how would one value the art or the company with so many unknowns? Well, there is a way.

It is difficult to collect data of peer startups working in the same industry, business model, management team quality, and in the same location.

In such cases, we would show the work to an angel investor who invests in comparable companies to get her input. We also compile data from Pitchbook and other databases to create a virtual market to support our conclusion.

This, however, is only the halfway point. Once we determine the entire company’s value, we allocate that value into different classes of stock since they have varied terms and ownership rights. Just as crude oil is refined into different products to cater to different demands.

Frankly, determining the company value is relatively straightforward compared to the allocation of value into different classes of stock. A wise valuator knows that the allocation is the Achilles heel in a 409a valuation.

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

Bharat Kanodia – Founder and Chief Appraiser