fair market value for startups

Understanding fair market value for startups

Fair market value (FMV) is a concept that, honestly, shouldn’t be that big of a deal to founders - except when it becomes an issue when a company’s stock option pricing is too high. For startups, determining the fair market value is a necessary evil for compliance with tax regulations and for issuing employee stock at a strike price that is satisfactory to the IRS and accounting auditors.

What is fair market value in the context of startups?

Fair market value for startups represents the estimated price at which a share of the company’s common stock would trade in an open market transaction between a willing buyer and seller. Unlike public companies where stock prices are readily available, private companies must rely on specific valuation methods to determine their FMV. So the FMV is supposed to represent what a reasonable buyer would pay for the company’s stock - usually the common stock.

Since most startups don’t have willing buyers of their common stock (and it might be illegal, given security regulations), startups pay accredited valuation providers who conduct what is called a 409A valuation.

Why FMV matters for startups

Understanding and accurately determining your startup’s fair market value is critical for several reasons:

  1. Compliance with IRS regulations
  2. Setting appropriate strike prices for stock options
  3. Attracting and retaining talent through equity compensation
  4. Explaining the value of warrants or equity comp to advisors and mentors

How to determine fair market value for your startup

The primary method for determining a startup’s fair market value is through a 409A valuation. This valuation, named after the section of the Internal Revenue Code that governs it, is performed by independent appraisers and provides a defensible FMV for your company’s common stock.

FMV valuation methodologies

When conducting a valuation, accredited providers typically use one or more of the following approaches:

  1. Market approach
  2. Income approach
  3. Asset approach
  4. Backsolve method

Market approach

The market approach often involves comparable company analysis. This method compares your startup to similar public companies to infer share value. It can be used for startups at various stages of development.

Income approach

The income approach focuses on the revenue generated by the company. It’s more suitable for mature startups with established cash flows. This method uses a discounted cash flow analysis to determine the net present value of expected future earnings.

Asset approach

The asset approach calculates the net assets of a company. It’s typically used for very early-stage startups that haven’t formally raised financing or generated significant revenue.

Backsolve method

The backsolve method is considered one of the most reliable ways to determine a startup’s value, especially when there’s been a recent financing round. Here’s how it works:

  1. Basic concept: If an investor pays $1 million for a 10% interest in a startup, the startup’s value would be $10 million.
  2. Complexity with preferred stock: VC investors typically buy convertible preferred shares rather than common stock. These shares have liquidation rights that supersede common equity but can also convert to common stock if the company performs well.
  3. Adjusting preferred to common stock price: 409A appraisers use backsolving to adjust the preferred stock price to a common stock price.

Backsolve valuation shortcut

A quick estimation method often shows that the common stock FMV is about 25% to 35% of the preferred price per share. For example, if investors paid $1 per share, the common stock might be valued at $0.25 to $0.35 per share.

However, we’ve seen it as high as 49% of the preferred stock price in certain circumstances - namely when a company has a high percentage of the cap table made up of preferred stock, and when the FMV is conducted close to a recent fundraising event.

Detailed backsolve process

The full backsolve method is more complex:

  1. It models the company’s shares as a series of call options on the overall equity value.
  2. The equity is assigned “breakpoints” where converting preferred to common stock becomes advantageous.
  3. Payoffs at each breakpoint are assigned probabilities and discounted to present value.
  4. The process solves for the value that makes the most recent financing round equal to the price investors paid.
Verifying FMV accuracy

The backsolve method provides a quick way for startup executives to verify their 409A valuation report’s accuracy. If the valuation falls within the 25% - 35% range of the preferred stock price, it’s likely accurate and defensible in an audit.

By understanding these valuation methodologies, particularly the backsolve method, startup founders can better navigate the 409A valuation process and ensure they’re receiving accurate and defensible fair market valuations for their company’s common stock.

Market approach for 409A valuations

The market approach is often the preferred method for startup valuations. It includes two primary techniques:

  1. Backsolve method: This uses your startup’s most recent financing round to create an option pricing model (OPM) and calculate share value. It’s particularly useful for pre-revenue startups or those with negative cash flows that have recently raised funds.
  2. Comparable company analysis: This method compares your startup to similar public companies to infer share value. It can be used for startups at various stages of development.

Income approach for 409A valuations

The income approach focuses on the revenue generated by the company. It’s more suitable for mature startups with established cash flows. This method uses a discounted cash flow analysis to determine the net present value of expected future earnings.

Asset approach for 409A valuations

The asset approach calculates the net assets of a company. It’s typically used for very early-stage startups that haven’t formally raised financing or generated significant revenue.

Factors affecting fair market value for startups

Several factors can influence your startup’s fair market value:

  1. Assets: The value of your company’s tangible and intangible assets
  2. Future cash flows: Projected revenue and profitability
  3. Comparable companies: Valuations of similar startups in your industry
  4. Market conditions: Overall economic environment and industry trends
  5. Recent funding rounds: The valuation implied by your most recent investment
  6. Material events: Significant changes like acquisitions, mergers, or major product launches

Fair market value vs. post-money valuation

It’s important to distinguish between fair market value and post-money valuation. While FMV represents the value of a single share of common stock, post-money valuation refers to the overall value of the company immediately after a funding round.

It’s important to realize that VCs are not going to use the FMV produced by the valuation firm as their benchmark for investing in the company. They’ll have their own valuation methods, and, quite honestly, often pay a lot more for their preferred stock than your common stock is work.

The importance of regular 409A valuations

Startups should conduct 409A valuations at least annually or whenever a material event occurs. Regular valuations ensure compliance with IRS regulations and provide a solid foundation for equity compensation decisions.

Choosing a 409A valuation provider

When selecting a provider for your 409A valuation, consider the following factors:

  1. Experience with startups in your industry
  2. Credentials and qualifications of the appraisers
  3. Audit-readiness of their reports
  4. Flexibility in approach
  5. Cost and turnaround time

Fair market value and startup equity compensation

Fair market value plays a crucial role in startup equity compensation. The FMV determined by your 409A valuation sets the minimum price (strike price) at which you can offer stock options to employees, contractors, and other recipients.

Stock options and FMV

When granting stock options, the strike price must be at least equal to the current fair market value of the common stock. Setting the strike price below FMV can result in tax penalties for both the company and option recipients, which is why startup boards with professional investors ask the founder to provide a 409a valuation report to justify the stock option prices that are approved.

IRS safe harbor and fair market value

In general, obtaining a 409A valuation from an independent appraiser provides “safe harbor” protection from the IRS. This means the IRS will generally accept the valuation unless it’s deemed “grossly unreasonable.”

Consequences of incorrect FMV

If the IRS rejects your company’s valuation, it could lead to serious consequences:

  1. Revised tax treatment of issued stock options
  2. Immediate taxation of options for employees
  3. Potential penalties for both the company and option holders

Fair market value for early-stage startups

While early-stage startups might be tempted to estimate their own FMV, it’s crucial to obtain a professional 409A valuation. This ensures compliance with IRS regulations and provides the safe harbor protection that’s essential as your company grows.

Conclusion: Mastering fair market value for your startup

Understanding and accurately determining fair market value is a critical skill for startup founders. By grasping the concepts of FMV, 409A valuations, and their implications for equity compensation, you’ll be better equipped to make informed decisions about your company’s valuation and stock option practices.

Remember, while this guide provides a comprehensive overview of fair market value for startups, it’s always advisable to consult with financial and legal professionals for advice tailored to your specific situation.