by Janet Chase, Kaufman Rossin
With the daily demands of running a business along with the financial pressures and challenges inherent in early-stage companies, a business valuation may not be the first thing an entrepreneur thinks of when he awakes each morning. But it’s an important consideration, especially for companies that plan to offer alternative compensation such as employee stock options, which will usually require a 409A valuation.
Startup companies are often cash poor and have little in the form of current monetary compensation to offer their employees. However, they can offer employees a share of the future pie that could come to fruition if the company’s ideas hit it big. This compensation can come in the form of a stock option, a stock appreciation right, or a similar financial instrument, which can potentially be quite lucrative for employees at the time of a merger, acquisition or initial public offering (IPO).
In order for the employees to not incur taxes on these instruments, the IRS tells us that the stock right must specify an exercise price (aka strike price) that may never be less than the fair market value of the underlying stock on the date the stock right is granted. This is where a qualified business valuation professional comes in – he or she can determine the fair market value of the underlying stock.
When does a startup company need a business valuation?
Valuation is usually important for startup companies both for income tax requirements and accounting requirements. The timing will vary depending on the purpose. For example, a valuation is usually needed for tax purposes when a) the company issues stock options for the first time; b) the company has a “material change” in their business such as a new financing; or c) it’s been more than 12 months since the last valuation. A valuation is needed for accounting or financial reporting purposes when the company’s auditor or another stakeholder, such as a bank, requires it.
Why is it important to hire an experienced valuation firm?
Valuations for startup entities are often highly complex due to the uncertain nature of early-stage operations. Incorrect reporting of share or option prices to regulatory authorities such as the IRS can lead to taxes and penalties. An experienced business valuation professional can help entrepreneurs with the complex and sometimes counterintuitive nature of startup valuations.
The following are examples of why these types of valuations can be tricky and may require outside expertise.
1. A company can have value, even if there is no current income or revenue.
Usually valuations for startup companies are performed using either projected financial statements or implied using the price paid for a recent round of financing. This can result in value even if the company has not sold one product!
2. Common shares can have value, even if other stakeholders contractually get paid first.
Current accounting regulations, under most circumstances, require companies to extrapolate the company’s value through a period of time until either an IPO or a merger or acquisition (M&A) transaction will happen. If this period is several years and it’s possible that the common shareholders will get a payout at any time during this period, the common shares will most likely have value under current guidance.
For example, in a matter where a company was valued at $50 million, preferred shareholders would have been due the first $60 million if the company were liquidated today. Under these circumstances, it would be tempting to surmise that the common shares have no value and set a very low strike price on the option, such as a penny a share. However, valuation firms, in most circumstances, are required to look beyond the current value and quantify the probability that the firm value will rise above $60 million at any time until an M&A event or IPO, in order to determine the value of the common shares. So in this instance, the common shares usually would have value significantly above a penny a share.
Firms that perform many 409A valuations have access to sophisticated databases and models to evaluate and quantify this probability.
3. If left to do a valuation on their own, companies have a tendency to derive the value based upon the implied pro rata share of a recent financing, which can result in overstating the value.
For example, in a matter where preferred shareholders paid $100 million for 800 preferred shares, and there were a total of 1,000 shares outstanding, many companies would assume that this implied a value of $125 million ($100 million / 0.80) for the company as a whole because the preferred shareholders bought 80% of the shares (and thus 80% of the company).
However, since the preferred shareholders had preferential rights, including the right to convert their shares to common shares and the right to receive a payout first upon a liquidity event, the preferred shares were actually worth a greater percentage (say 90%) of the company for the $100 million that was paid. This would imply an overall value for the company of $111 million ($100/0.90) rather than $125 million.
Firms that have experience valuing these types of interests have the expertise to use mathematical models to capture the impact on value that these rights and attributes have.
Janet Chase, CPA, ASA, ABV, is a director of business valuation in Kaufman Rossin’s Miami office. Kaufman Rossin is one of the Top 100 CPA firms in the U.S. and provides business valuation services to companies in a variety of industries. Janet can be reached at email@example.com.