409A Valuation Vs VC Valuation: Know The Difference

As a startup founder, you often juggle between multiple roles, you spend countless hours building your product, assembling your team, and securing funding from venture capitalists who believe in your dream. Now, as the business grows, in order to attract and retain the best talent, you are willing to provide stock options to new and existing employees. 

However, this decision requires you to deal with IRS (Internal Revenue Services) requirements and other complexities, including the need for an independent third-party 409A valuation. This valuation is crucial to determine the fair market value of your company's common stock, and it is distinct from the valuations provided by venture capitalists or discussed during funding rounds. 

In this blog, read about the differences between 409A valuations and VC valuations and what this process entails for you.

Basics of Valuation

Assessing the value of a startup is an intricate process that requires detailed insights into its financial health, prevailing market dynamics, and prospects for growth. As per experts, the actual valuation of a company is considered to be its Fair Market Value (FMV). 

According to the IRS, FMV is the price at which both the buyer and seller are amicably willing to make a deal without either party being forced into it. It is essential that both parties have the necessary facts and knowledge about the agreement.

When undergoing a valuation, organizations must consider the following factors:

• No compulsion or forceful negotiation: The transaction should be fair, with no forced negotiations. This approach ensures that the valuation reflects the true worth of the company rather than being affected by external pressures.
• Both parties should have reasonable knowledge of relevant facts: The buyer and seller should have all the pertinent information about the deal. This includes understanding the company's financial health, its growth prospects, and the market conditions.

As the stocks of publicly listed companies are sold and bought in the open market, it is relatively simple to value them. However, the process of valuing private enterprises is complicated due to the limited data available. For instance, if you purchase 1% of a publicly listed company for a certain amount, you can easily calculate the total value of the business. However, for private companies, this is not the case. 

The valuation of private companies often involves complex methodologies and requires expert knowledge. This is where understanding different types of valuations becomes crucial for startup founders.

Recommended Read: An Intro To Startup Valuation Methods

What is 409A Valuation?

Section 409A of the Internal Revenue Code offers a detailed framework for the taxation and regulation of non-qualified deferred compensation. A 409A valuation is essentially a third-party appraisal of FMV of the company's stock.

This valuation is crucial for US-based private companies when they want to offer equity to their employees. It helps them avoid severe IRS penalties by ensuring that all stock options and Stock Appreciation Rights (SARs) are granted with their exercise price set to the Fair Market Value (FMV) of the underlying common shares at the time of issuance.

409A Valuation Methodologies

409A is applicable to any company that has US-based plan participants. It does not matter if it is a local US company or an enterprise registered elsewhere that has US employees. Let’s have a look at the different methodologies used for 409A valuation:

• The Discounted Cash Flow Analysis method estimates an investment's value based on the expected future cash flows. It uses a discount rate to calculate the present value of expected future cash flows and compares it with the initial investment.
• Asset / Cost-to-Recreate Approach approach measures the value of an asset by the cost of replacing it with another asset of similar utility. It considers the net aggregate fair market value of the underlying individual assets and liabilities of an entity.
• Transaction (or M&A) Comparables Analysis method uses past M&A (Mergers and Acquisitions) transactions involving similar companies to value a business. It looks at companies with a business model similar to the one being targeted.
• Public Comparables Analysis method compares public companies operating in a sector and location similar to the valuation company. These are entities with comparable revenue and market capitalization.
• The Backsolve Option Pricing Model is an option-based valuation method based on pricing from the company's latest transaction. These transactions could be an acquisition, the latest round of financing, the Black Scholes option pricing formula, or a waterfall allocation schedule.

What is Venture Capital Valuation?

Venture capital valuation is a financial estimate of an enterprise’s worth that venture capitalists require before offering an investment. VC valuation is a crucial step to secure funding for startups and high-growth businesses.

Venture capital investors provide funds to new or small businesses in exchange for a percentage of ownership in the company. Investors use the VC valuation to determine the potential success of the firm. They will not invest in any company if they do not foresee a good return on their investment.

To illustrate, let’s consider an example with the Discounted Cash Flow (DCF) method. Suppose your startup is seeking to raise $5M for its Series A investment round. Your company is expected to grow to $80M in sales and $8M in profit by Year 5. The business ‘comps,’ i.e., comparable companies, are trading for 8x earnings, implying an expected exit value of $64M ($8M x 8x). 

The VC firm’s desired rate of return is 25%, which is then applied to the DCF formula: $64M / (1.25)^5 = $20.6M. This $20.6M valuation is the post-money value. Subtract the initial investment amount of $5M from this to get to the pre-money value of $15.6M. 

The pre-money valuation of $15.6M is crucial as it has a direct impact on the VC’s decision. It reflects the startup’s worth before investment and also determines the equity stake for the investor. All VC negotiations are based on pre-money valuations and they reflect the critical number on which all parties must agree for a funding round to proceed.

On the other hand, post-money valuation refers to the company’s worth after it receives investment money. This valuation includes outside financing or the latest capital infusion. Both these valuations are crucial in determining how much a company is worth, with the main difference between them being the timing of the valuation.

Differences between 409A Valuation and Venture Capital Valuation

Understanding the differences between 409A Valuation and Venture Capital Valuation is crucial for startup founders. These valuations, while serving different purposes, play a significant role in a company’s financial journey. Here is a comparative analysis for your perusal.

Timing

409A valuation is required before a private company issues any equity or stock to its employees. A 409A valuation should ideally be undertaken every 12 months or sooner in the case of a material event. Such material events could include significant occurrences such as a merger or acquisition, a significant financing round, a change in management, or a change in the business model.

On the other hand, venture capital valuations are performed as part of the due diligence process before venture capitalists invest in a company. This valuation helps them determine the company’s present value and future potential.

Valuation Approach

409A valuation process involves analysis of the company’s financials, projected cash flows, and growth prospects. It uses various methods, such as the income approach, which projects future cash flows and discounts them back to their present value. The market approach compares the company to similar publicly traded companies or recent transactions.

In contrast, venture capital valuation assesses a business’s value based on its industry, growth stage, and market positioning. It calculates the value that venture capitalists require and informs them about the viability of startups they are planning to invest in. VCs use different variations of pre-money and post-money valuations to arrive at a decision. 

While both valuations aim to determine a company’s worth, they serve different purposes and are used in different contexts. The 409A valuation is more focused on regulatory compliance and stock option pricing, while the venture capital valuation assesses the potential return on investment for venture capitalists.

Focus

The 409A valuation, mandated by the IRS, focuses on determining the value of the common stock for employee incentives. It involves key players within the company, including the management team, the board of directors, and the employees who are the recipients of the stock options. The outcome of a 409A valuation directly impacts stock option pricing and ensures the company’s compliance with tax regulations.

On the other hand, VC valuation is performed to determine the investment amount by the VC firms. It involves venture capital firms, the company’s management, and the board of directors. This valuation offers an in-depth assessment of the company’s value and future potential, helping venture capitalists make informed investment decisions. The VC valuation plays a significant role in determining the ownership structure of the company post-investment.

What if the 409A valuation is lower than expected?

As a startup founder, you might find that your company's 409A valuation is lower than you expected. While this might initially seem concerning, it is essential to understand the context of this valuation. The 409A valuation is mainly used for tax purposes and to price stock options for employees. It is not a reflection of your company's overall market value or its growth potential. We already have a detailed blog answering many of the 409A valuation questions for startup founders in our blog. 

A low 409A valuation does not mean a low VC valuation

The 409A valuation and the VC valuation serve different purposes and are used in other contexts. The 409A valuation is a regulatory requirement for private companies granting stock options. It is designed to ensure that stock options are not given with an exercise price below the fair market value of your common stock. On the other hand, a VC valuation is a negotiation between entrepreneurs and venture capitalists, reflecting the perceived future potential of the company.

A lower 409A valuation can benefit employees by granting them lower-priced stock options, which provides them with greater potential for future gains. However, it is important to note that VC valuations are rarely influenced by 409A valuations, so a lower 409A valuation does not necessarily lead to a lower VC valuation.

409A Valuation Vs Post-Money Valuation

Post-money valuation is the estimated worth of a company after external financing or capital infusions are included in the balance sheet. This investment valuation covers the latest round of funding, ownership dilution, and the rights of the newly issued preferred shares. For instance, if a company is worth $10 million (pre-money) and an investor invests $2 million, the new post-money valuation of the company will be $12 million.

Here’s how 409A Valuation differs from Post-money Valuation.

Purpose of valuation

The 409A valuation is an independent appraisal used to determine a fair market value of a company's common stock. This fair market value is important for tax purposes, especially when setting the exercise price for employee stock options. Meanwhile, the post-money valuation reflects the estimated value of a company after it has received a round of funding.

Method of valuation

The 409A valuation is performed by compliance experts and is an estimate at the low end of a reasonable valuation range. It takes into account the rights and values of different classes of stock. Post-money valuation is the market value of the stock negotiated between entrepreneurs and venture capitalists.

Impact on future fundraising

The 409A valuation and post-money valuation can impact future fundraising in different ways. A lower 409A valuation can make stock options attractive for your employees, which can help attract and retain talent. Post-money valuation, on the other hand, can influence the terms of future funding rounds.

Understanding the differences between ‘409A Valuation’, ‘VC Valuation', and ‘Post-money Valuation’ is important for startup founders. While serving different purposes, these valuations play a significant role in a company’s financial journey, influencing everything from fundraising rounds to employee stock options. 

As a founder, having an in-depth understanding of these financial terms can help you navigate your startup’s financial landscape with confidence.

About Qapita

Qapita is a platform designed to help businesses with their 409A valuation and other equity management needs. With Qapita’s extensive equity management solutions, you can streamline your company’s equity management process, from Cap Table Management to liquidity events. The platform is intuitive and user-friendly, making it easy for you to manage your company’s equity, even if you are not a financial expert. 

So why wait? Connect with experts at Qapita and take the first step toward simplifying your equity management process.