Startup Fair Market Value: Essential Guide for Founders

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.