When it comes to private company 409A valuation it is helpful to first have some context in terms of how to think about it. First, 409A valuations are a tax compliance issue. They are not the value of your company upon an acquisition or the pre-money that you might go out and raise a round at. When we think about valuation we think in terms of a continuum, at one end is the exit that you are dreaming of and will make you rich. At the other end is possibly a liquidation value. What they assets of the company might go for if you had to shutdown. Could be as low as zero. At any one point in time a company can have a value spectrum depending on motivations, purpose of the valuation, information asymmetry, etc….
What we aim for in 409A is to try and get you the lowest possible answer that is still defensible against an audit. So it tends to be on the lower side of the continuum. If you are unsure if you need a 409a valuation then find out here.
1. Include Planned Option Grants in the 409A Valuation
Include planned option grants for the coming year, even if it is an estimate. Companies often don’t include this or think it is relevant to the 409a valuation and often the valuation firm does not think to ask about it. We include the options in the 409a valuation of a venture backed company when using an option pricing model. Including these planned grants can draw value away from the common stock. The mathematical explanation of why is beyond the scope of this article but it does help a little bit.
2. Make Sure Your Cash Runway is Reflected
There are several defensible ways to make sure this is accounted for in a 409A valuation. We typically take cash runway into account when considering the time to exit, which is an input into the option pricing model. I’m not going to fully explain these methods here as a lot of other valuation firms do not know how to do this and still keep the valuation defensible. Having said that, I would encourage you to ask the person selling the valuation as to how they do this or better yet call me and we will do the 409a for your company.
3. Make Sure Volatility is Reflective of a Startup
Volatility is an input into the option pricing model which is used in most venture backed 409a valuations. Statistically, higher volatility is negatively correlated with size of a company. This makes sense, more diversified and stable companies will be less volatile in their performance, think blue chip versus micro-cap stocks. The mathematical relationship between the volatility and your common stock price is not straightforward but ask your valuation firm to play around with the input and optimize it.
Typically, smaller companies have higher volatility which results in a higher value from an option pricing model. But the same volatility (or roughly the same) will be used to calculate a marketability discount which will also result in a higher discount to the common. So they kind of offset each other but it really is a little more complicated than that. So just ask your analyst to optimize it.
4. Use Conservative Financial Projections.
I think this is self explanatory. The more optimistic the projections then typically the higher the valuation. But keep in mind that a valuation firm should also be looking at expenses as well. If the firm is utilizing a discounted cash flow approach I would ask about to weight this approach as little as possible as we all know how reliable startup projections are.
5. Ask About the Discount For Lack of Marketability
This is a discount that is taken as their is no active and liquid market to sell your common share of WrestleNow or whatever other startup you work at. And while the valuation profession has inched forward on how to deal with this in a 409A valuation a wide range is still applied. In my experience how aggressive a DLOM (Discount for Lack of Marketability) applied in a 409a depends on the stage of your company, who your auditor is , and how well the valuation firm your dealing with can defend their selection. Firms less experienced with early stage startups tend to be too low or too high. Having said that, ask about the range, if they can be more aggressive and/or make the case of just how unmarketable your shares are you should be able to bring this higher and your common value lower.