What Every Early Stage Company Should Know About Common Stock Valuations

Prior to 2004, it was common practice to set the fair market value of common stock for purposes of setting option exercise prices by loosely estimating an appropriate discount from the price of recently issued preferred stock. The discount to the most recent preferred stock price was generally based on the company’s stage of development.

If you’re a CEO or a CFO of an early stage company, you’ve probably heard advisors talking about “the good ‘ole days” when determining the fair market value of common stock was much easier and commonly pegged at 10.0% of the preferred stock price. However, rules of thumbs like this no longer satisfy the new valuation rules under the Internal Revenue Code Section 409A (“Section 409A”). Section 409A contains detailed guidelines for determining the fair market value of the common stock of a privately held company and requires a “reasonable application of a reasonable valuation method” (see Sidebar).

5 Factors Impacting Your 409A Valuation

1. The complexity of the capital structure of the company is quite possibly the most important factor in determining the scope of an engagement under Section 409A and is a critical component to determining the value of common stock. Companies with a single class of stock can generally be valued using traditional valuation methods (e.g. market approach, discounted cash flow, etc.). However, companies with multiple rounds of preferred funding require a thorough understanding of the rights and preferences, including share classes ranking, liquidation preferences and conversion rights, held by each class of stock. They impact the expected value for each class of stock and therefore must be considered. The more complicated the capital structure, the more complicated the valuation.

1. The quality of the financial reporting is often overlooked, but remains critical to the valuation process. Audited financial statements prepared by a reputable accounting firm will not only simplify the valuation process, but also reduce the perception of risk for an investor. Internal or interim financial statements and management’s ability to tie them to the audited statements will further reduce the complexity of the valuation process.

1. Understanding both a range of possible outcomes, as well as the expected projected results is a key component to the valuation process. Whether this is evidenced in a single year budget or in five year projections depends greatly on the company and ability of the management team to forecast results. The company’s ability to clearly detail and justify projections evidenced both by a track record of meeting and/or exceeding projections, as well as understanding of the inputs used in the forecast, often reflects the strength of the company’s management team. Additionally, the capital requirements of the business, the company’s market share relative to competitors and margins as they relate to the industry are key components of the valuation process.

1. The availability of data for guideline public companies affects which valuation approach is most evident. Emerging companies in a relatively new market space may not have truly comparable publicly traded companies. Conversely, emerging companies in established industries often have multiple transactions that may provide evidence of value. Market data includes evidence from the publicly traded markets and private company transactions that is often available upon subscription. Market trends and data quality are often important factors to consider. Whether it includes publicly traded companies or recently acquired businesses, both can be critical in the valuation process.

1. The final factor, that can affect the valuation process, is the industry in which the company competes. New and upcoming industries can often pose a challenge to clearly determine value drivers. Some industries have multiple types of companies competing for the same market share, such as restaurants or retail, while others are dependent on evolving technological advances such as software or consumer electronics. The fit of a company within a broad industry category or its unique positioning can impact both the complexity and relevance of industry research.

When to Hire an Independent Appraiser

Over the course of Quist’s valuation experience, we observed that the valuation need and ability to afford an independent appraisal is directly correlated with the stage of the company’s development. The extent of the investigation required to determine a company’s value typically drives the cost of a valuation. Depending on the company’s stage, revenue, complexity, capital raise activity, number of locations, intellectual property and other factors, the price for a 409A valuation can vary too.

Many start-up stage companies are reluctant to engage a qualified independent appraiser to perform their company’s valuation due to a lack of capital. Those companies may be willing to take some risk, however, because reasonably priced valuation services tailored specifically for the needs created by Section 409A are now being offered in the market, even some early stage companies may consider that the cost of an independent appraisal is justified by the benefits afforded.

Once a company is beyond the start-up stage and has reached the stage when it takes its first significant investment from outside investors, boards that gain truly independent outside directors as a result of the investment transaction will be more likely to conclude that an independent appraisal is advisable. Venture capital investors typically require the companies they invest in to obtain an outside appraisal. Companies that have either begun to generate significant revenues or that have completed a significant financing will both be more capable of bearing the cost of the independent appraisal and be more concerned about possible liability for the company and for employees if their valuation is subsequently determined to have been too low.

A common practice that has developed is to have an initial appraisal performed and then to have that appraisal updated semi-annually or quarterly, depending on the company’s circumstances, and to plan option grants to occur soon after an update. The only caveat is that if a company has experienced a significant value-changing event since the most recent appraisal, the company must advise its appraiser of such event in order to incorporate all relevant information in the updated appraisal.

Lastly, companies contemplating an IPO will be required – initially by their auditors and later by the SEC’s rules – to establish the value of their stock for financial reporting purposes using an independent appraiser. Companies planning to be acquired will be advised that prospective buyers will be concerned about compliance with Section 409A and will require evidence of defensible option pricing, typically the independent appraisal, as part of their due diligence.

At any stage, a valuation done by a qualified independent appraiser is one of the three Safe Harbors that is presumed to result in a reasonable valuation if the valuation date is no more than 12 months before the date of the option grant.  In order to challenge the value determined under a Safe Har­bor, the IRS must show that either the valuation method or its applica­tion was grossly unreasonable.

Please feel free to contact the Quist team for assistance and advice when considering your company’s valuation needs.