One important financial question companies ask more than any other: What is the difference between a 409A valuation and a venture capital (VC) valuation?
409A valuations and VC valuations are very different. 409A valuations are point estimates at the low-end of a defensible valuation range performed by compliance experts. VC valuations are market values negotiated between venture capitalists (VCs) and entrepreneurs.
VCs rarely even consider 409A valuations as an input into their valuations. But 409A valuation providers almost always consider the value that a VC would use.
To understand the question, we have to dive into a bit of valuation theory.
In this post, we’ll cover the following topics:
- Valuation Theory
- No Compulsion
- Reasonable Knowledge of Relevant Facts
- The Price of Transaction between a Buyer and a Seller
- Comparability, Frequency and Certainty
- Valuation Ranges
- Valuing Companies
- 409A Valuations
- Venture Capital (VC) Valuations
- Pros and Cons of the 409A Approach vs the VC Approach
- Implications for Your Company
Valuation professionals refer to the value of an asset as its fair market value. The IRS defines fair market value as:
The fair market value is the price at which … property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
Three things jump out of this definition:
- Valuation is the price of a transaction between a buyer and a seller
- There can’t be compulsion to buy or sell for either party
- And both parties need to have good information
Let’s look at these last two points first.
The definition of fair market value implies you can’t claim a transaction is fair if it involves force. This is pretty obvious. Let’s say Jon blackmails Sarah into selling him her house in the Hamptons. It’s unlikely that the price Jon pays would be the same price Sarah could get if she listed the house.
So the IRS would say that this transaction doesn’t represent a “fair” value for the house.
The definition of fair market value above had another important clause. Both the buyer and seller need to have a “reasonable knowledge of relevant facts.”
What does that mean?
Let’s assume you don’t have the best personal ethics. You want to sell your house. Problem is, it has a leaky roof. It will cost at least $10K to fix it. How can you solve the problem?
If you didn’t care about personal ethics, you could show it on sunny days and not mention the leaky roof. You could find a full-price buyer. If a buyer knew that the roof was leaky, they would insist on a lower price. So you keep the information to yourself.
This is an example of information asymmetry. Information asymmetry occurs when one party has relevant information they withhold from another.
Again, in this situation the negotiated value of the house is not considered fair.
Fair market value is “the price at which … property would change hands between a willing buyer and a willing seller.”
This implies we can find the value of anything by buying or selling it (assuming its a fair deal).
That means it’s easy to discover any asset’s value, right?
Not so fast…
There is one big problem with this approach. Usually buyers and sellers want an estimate of an asset’s value in advance before they transact.
So why not look up what other people have paid for similar assets?
It turns out this is a good idea.
Let's say Ryan needs a new car and has decided on a Toyota Camry. Ryan doesn’t care about any attributes except for the mileage of the car. Here, we've plotted all the used Toyota Camrys that have sold in the Boston area on a graph using Internet data. It looks like this.
Ryan assumes Camrys are pretty much the same except for mileage. Then, he estimates the average decrease in value for every extra mile on a Camry. Based on this, he can find a good “fair” price for a Camry no matter how many miles it had.
Buyers and sellers often want an estimate of an asset’s value before they transact. So valuation often relies on finding recent sales of similar assets to one you want to value. These similar assets are “comparables, ” or “comps.” The idea of comparables is very important in valuation. Valuation professionals use comparables to find the value of many assets. We’ll discuss it more in just a few minutes.
It’s pretty easy to get valuation estimates for products that people buy and sell a lot (like Toyota Camrys). You can use the prices of these transactions to understand what a fair (or better than fair) price would be.
But it gets harder when you need to value you something people don’t buy and sell often.
|Take a minute to think about how you would estimate the value of the original Starry Night painting by Van Gogh.|
You might notice a problem. There aren’t many other sales involving the original “Starry Night” by Van Gogh.
So what are our options?
We could look at previous transactions involving Starry Night. But valuations often increase over time for great art.
Usually, we have to cast a wider net to find comparables in situations like this:
- Look at recent sales of other masterpiece paintings
- Look at recent sales of other Van Gogh paintings
Several problems crop up when we are estimating valuation from infrequent transactions. Small market changes can affect the price in big ways. For example, the largest buyer of Van Gogh’s might die. Or a life-long Van Gogh lover could sell the company she founded and now have means to buy one.
This leads us to a big point. Two big factors affect the reliability of a valuation estimate comparability and frequency.
Comparability refers to how similar one asset is to another. The most similar “comp” to an asset is the asset itself. So the best estimate of the value of an asset would be a recent sale of the very same asset. Some assets also have “identical twins.” For example one barrel of crude oil is identical to another. So if you want an estimate of the price of a barrel of crude, you can look at a recent sale of another barrel of crude.
Frequency refers to how often and how recently an asset or a comparable asset sells. Crude oil barrels sell thousands of times every day. So you can be sure that the price of any one of those barrels is an indicator of the value of a barrel you want to sell.
When comparability is high and comparable assets sell frequently, our certainty of the value of a similar asset is also high. When comparability is low and comparable assets sell infrequently, we can’t be too sure of the value of an asset.
So valuation professionals often use valuation ranges to handle lack of certainty.
It’s possible for two people to sell the exact same asset for a different price. For example, Sally may be a better negotiator than Jill. So she might get a different price for the same asset.
So even fair market values may only provide an “average” estimate of the value of an asset.
When dealing with uncertainty, you may have seen confidence intervals before.
Confidence intervals allow us to say that a value lies on a range with some degree of certainty. You might say:
“I’m 90% confident that the temperature tomorrow will be between 80 and 90 degrees Fahrenheit.”
We can do the same thing with valuations when we have uncertainty.
Private companies are often painful to value. Public companies are easy. Small pieces of them (called stock) trade hands every day. It’s easy to infer the value of a public company with certainty from its stock.
Investment bankers pioneered an approach to value private companies using confidence intervals. They use a chart called the football field.
The football field shows valuation ranges for a company using different valuation approaches. In the chart above, the Discounted Cash Flow method yields results ranging from $48M to $75M.
Public comparables using a 2012 P/E ratio yield valuation ranges from about $58M to $75M.
So valuation ranges provide useful estimates even in uncertain situations. Like valuing private companies.
As mentioned above, valuing public companies is easy. Every day investors buy and sell thousands of small percentages of the company. These are fair transactions. Both sides have equal information and there is no compulsion to buy or sell. So they represent accurate prices.
If you know the value of a small part of a pie, you can use simple math to deduce the value of the whole. If you bought 1% of IBM for $100M, then you know the entire company is worth $10B. (In reality it’s a bit more complicated but this is the basic idea).
Valuing private companies is harder. First, there are few if any stock transactions you can look at. Second, many private companies are growing or changing fast. So estimates of value need to change.
- Cost/asset approach. Finding the value of a company by summing the costs of rebuilding the company or its assets.
- Income approach. Finding the value of a company by estimating the value of its future cash flows.
- Market approach. Finding the value of a company by looking at values of comparable companies.
409A valuation professionals consider these methods when they value private companies. They build complicated financial models using these approaches.
VCs value companies using gut feel, experience, and the Venture Capital Method. The Venture Capital Method is also called the First Chicago Method.
Let’s look at both approaches in more detail.
In the early 2000s, the US government enacted regulations around common stock options. This resulted in a new section of the internal revenue code: IRC 409A. We don’t have time to cover it all in this article but you can find a thorough summary of 409A here.
The basic thrust of 409A is to make it costly for companies to issue stock options below fair market value. But regulators didn’t want the rules to affect startups too much. So they created and escape hatch for “small, illiquid companies” (read: startups). Startups can pay for a 409A valuation from an independent valuation firm. This qualifies startups for safe harbor–which eliminates most 409A risk.
Qualified 409A professionals use many valuation approaches. The most common are:
- Backsolve Option Pricing Model. Uses the most recent sales of preferred stock to infer a valuation.
- Public Comparables Analysis. Uses public companies to infer a valuation.
- M&A (or Transaction) Comparables Analysis. Uses transactions acquisitions of other companies to infer a valuation.
- Asset / Cost-to-Recreate Approach. Uses the value of the company’s assets or the cost of buying similar assets to infer a valuation.
- Discounted Cash Flow Analysis. Uses the projected cash flows of the company to infer a valuation.
The 409A firm picks the approaches it considers most reliable. It uses the implied valuation from these approaches to estimate a company’s value. Sometimes the firm will weight many approaches to find a weighted average.
Here’s how Shareworks Startup Edition software weights different valuation approaches:
The valuation professional performing this valuation weighted 4 methods at 25% each
- Invested capital
- Public comps,
- M&A comps, and
The IRS requires 409A valuations to establish a point estimate of the value of common stock.
|A point estimate is a single-number approximation of value as opposed to a range of values.|
409A valuation firms pick a point estimate that is toward the low end of a defensible range of values. They do this because their clients want the valuation to be as low as possible.
Clients want a low 409A valuation. This allows them to grant stock options to their employees at a low price.
Why don’t 409A valuation firms perform valuations that undervalue the company?
There are several reasons:
- Valuation professionals agree to professional ethics that prevent them from doing this
- Valuing a company at an low price would put the firm at risk of IRS action
- This risk of IRS action is also a negative for the client
So most 409A valuation firms try to give valuations that are toward the low-end of a defensible range.
Defensibility refers to the likelihood a 409A valuation could withstand attack. So the more defensible a valuation is the safer it is from “attacks” like an IRS audit.
VC valuations come from actual transactions when a VC buys shares in a private company.
Let’s say a VC firm buys 1M shares for $5M. This means they paid $5.00 / share. VCs assume the value of a company is the price / share they paid times the company’s outstanding shares. If there are 5M shares after the VC invests (including the 1M shares the VC owns), the company would be worth $25M.
VCs have some fancy words for their valuations. They call the $25M number in the example above the company’s post-money valuation. Post-money means it represents the value of the company after the $5M investment.
It makes sense if you think about it. Let’s imagine a cool new startup called Spiff. Let’s say Spiff is worth $20M right now at this exact moment. Now imagine that in 5 minutes everything about Spiff will be exactly the same but the company will have $5M more.
How much would Spiff be worth after the $5M incremental investment. Assuming nothing changed in the last 5 minutes, it makes sense that Spiff would be worth $25M. (It was worth $20M 5 minutes ago plus it now has a $5M more in cash).
VCs call the value of a company before their investment the pre-money valuation. In the example above, Spiff’s pre-money valuation is $20M and its post-money valuation is $25M.
|Pre-money and post-money math is pretty easy. There are really only a few formulas you need to remember.
Post-Money Valuation (version 1) = Total Company Shares * Price Per Share the VC Paid
Investment = Price Per Share the VC Paid * Number of Shares the VC Bought
Pre-Money Valuation = Post-Money Valuation – Investment
Post-Money Valuation (version 2) = Pre-Money Valuation + Investment
Post-Money Valuation (version 3) = Price Per Share the VC Paid * Total Number of Shares Outstanding after the Round
This helps us understand VC vocabulary. But how do VCs actually determine that a given valuation is one they are willing to offer a startup?
Here’s the rub…
It’s kinda complicated. But it boils down to a model called the VC Method. It’s beyond this article to cover the VC method. But you can and should learn about the VC Method in this companion article.
On a side note: Every sophisticated entrepreneur should understand how VCs will value their company. Click here to download this VC model that will help you:
Where would VC valuations show up relative to 409A valuations? Generally, they will be higher. 409A professionals try to find a valuation toward the low-end of an acceptable range. VCs don’t. VCs want to find a valuation entrepreneurs will accept. This is more of a middle-range value.
Average VC valuations change depending on trends in the market for VC funding. But we're going to represent the average VC valuation like this:
Well, OK. 409A valuations are almost always lower than VC valuations. Should that concern us? Only one valuation is correct, right?
We don’t need to worry, here’s why…
VC valuations aren’t designed to hold up under IRS scrutiny. They are market-driven and that’s a big plus but they have other problems. VCs arrive at the valuation using gut-instinct. Plus, the math of the VC model violates a few core valuation principles.
For example, VC math assumes every share in the company has the same value. The VC model assumes that common stock is worth as much as Series D that has several benefits over common stock:
- Potentially hundreds of millions of liquidation preferences
- Board rights
- Superior voting rights
- Rights of co-sale, drag-along, etc.
|To understand those terms better check out our article on term sheets.|
409A Valuations have a very different purpose. They provide an IRS-defensible valuation of a company. But remember these valuations will generally be at the low end of an acceptable range.
Almost every entrepreneur wonders whether their 409A valuation will affect VC valuations.
The answer is easy: 409A valuations will not affect VC valuations.
VCs understand that 409A valuations are compliance-focused. They understand 409A valuations will be at the low-end of an acceptable range.
But even more, they would never trust a 409A valuation firm to tell them the value of a company. For better or worse, VCs feel like valuing companies is a core competency. The implications of valuations decisions have massive impacts on their business. So they won’t trust a 3rd party with this decision.