The True Value of Your Startup - 03/28/2009

Recently I have been doing quite a bit of work assisting clients with valuations for the purposes of issuing stock options. Stock options are a critical component of the compensation model for startups. So-called “409A valuations” (at least in the US) are used to establish the value of your company to allow you to set the fair market value exercise price for stock options to be issued as compensation.

Section 409A of the revenue code was enacted following the events at Worldcom, Enron, etc when executives ran away with millions by playing games with deferred compensation. Now section 409A of the code covers deferred compensation and most importantly for startups now sets rules regarding what is required to establish fair market value of stock options – rendering prior “rules of thumb” useless. Doing an appropriate valuation when issuing stock options will create an important presumption that the valuation of the stock reflects the fair market value and put the burden on the IRS to prove otherwise.

Larger startups will normally have an independent valuation specialist do 409A valuations, but seed stage startups such as I often work with need to do most of this internally as a practical matter: they have no money. Needless to say, company founders are not always excited by the final number, especially in this market. They often ask why the value of their company is not higher – especially in light of my prior post on valuing software startups for angel investors. I wanted to talk about these two critical valuation processes and provide some insight into why 409A valuations for early stage companies will often be a lot lower than valuations that are proposed to investors.

It might be easiest to first talk about the times when the numbers should be exactly the same. The total value of your company from a 409A valuation perspective and from an investment perspective should be the same whenever an investment is about to occur or has just occurred. This makes sense. If an independent investor agrees to put money into your company at a certain valuation, then by default you have established an independent value for your company. Therefore that valuation can be used to both derive the price-per-share of the investment, and can be used to derive an exercise price-per-share for stock options granted at approximately the same time.

The only thing to realize is that investors usually (but not always) buy preferred stock, while stock options typically cover common stock. This means that although the company valuation is defined, the actual market value will vary between the preferred stock, which has specific extra rights and is therefore more valuable, compared to the common shares, which are less valuable – especially once the preferred class is created. The key point is that when an investment occurs, that is usually a good time to issue stock options as well because a clear, independent value for the company has been established by the new investors.

A valuation challenge occurs however when you want to issue options but there is no active investment process underway. Without an independent investor agreeing to a value of your company for investment purposes, you need to compute a valuation using other methods. Methods can include one or more of a) calculating the value based on comparable companies in the market, b) calculating the value based on expected future profits and cash flows, and c) calculating the value by computing the replacement value of the company’s assets, usually software in my case. These methods produce a baseline valuation for the company that be used to set exercise prices for stock options.

However, the valuation produced by these methods for an early stage company tends to be a lot lower than the number you would include in a proposal for prospective investors. This really bothers some entrepreneurs: “Why are you saying my company is only worth X when you also state that we should be able to propose a valuation of 3 times X for investors when we are ready to raise money?”

The reason the numbers are different is that most valuations proposed to investors are bogus when it comes to the true value of your company.

A typical angel investor will look at dozens of deals before investing in one, and stats show that on the order of 3% of companies actually get funded by angels. That means that 97% of companies that are presented do not actually get funded, and therefore the valuation proposed for those 97% of companies is completely unrealistic – the company was clearly not worth the valuation being requested. Even those that do get funded often go through a process whereby the valuation is negotiated downward. This means that the valuation proposed to investors is almost always an “optimistic” valuation, one based on a built-in assumption (and a false one) that your company is worthy of being funded. Only 3% of companies will be so fortunate and even then the valuation will be further negotiated.

So without finding an independent investor who agrees to or negotiates a valuation, the optimistic or proposed investment valuation is not the true value of your company. In practice it would be wrong over 97% of the time.  Therefore the true value of your company is most likely a lot less than you would propose to investors. And the various valuation methods I talked about above help us make a good guess at what that true valuation might be. In some simple cases, it boils down to calculating how much you have spent developing your product so far, making a few adjustments, and basing the whole valuation on that result. The logic is that any other company that wanted what you have would need to spend a similar amount of money, therefore for a pre-revenue software company, this calculation can give you a pretty good idea of what the value of your company is for 409A purposes. This is heavily simplified so you should always work with a board member or other advisor to perform valuation calculations and document them appropriately.

One final point I want to discuss is that in this market, especially for later stage startups that have made a large investment in building product, the company can actually be worth a lot less to investors than the total prior cash investment. For semiconductor companies right now, there are a lot of “down rounds” happening. This means a new investment is happening at a lower valuation than the last one. Often the new valuation is less than the total funds invested into the company in the past - the company has lost significant value. Down rounds are never pleasant for anyone – founders can be significantly diluted, early investors can be “crammed down” by new investors, prior investors may have to put in more money to maintain preferred share status, and the like. Sometimes shuttering the business can actually be easier. I only point this out because in some cases looking at the asset value of your company can produce a number much higher, rather than lower, than it would actually be worth to investors.

In the end valuing your startup is not a straightforward science. However it is critically important to do an appropriate valuation when you want to issue stock options. Issuing stock options with an exercise price that is below fair market value triggers tax liability for the recipient and could lead to under-withholding by the company from a payroll perspective. And now with section 409A of the code enacted, issuing stock options with an inappropriate exercise price can trigger additional penalties of 20% of more. Therefore it is critical to find an experienced advisor to help you when you are ready to issue stock options to key employees, consultants, and service providers. Stock options are one of the most exciting upsides to working in a start-up – the last thing you want to do is mess them up so the recipient ends up paying extra taxes and penalties to the IRS.

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