The two faces of startup valuation

Tax ramifications are driven by the value of the stock.

This raises the question: how is stock valued? For tax purposes, fair market value (FMV) is defined as the price at which the property would change hands between a willing buyer and a willing seller, both having reasonable knowledge of relevant facts. For publicly traded companies, this value can be established relatively easily based on actual trading activity. However, establishing that value for private companies is more complex.

Let's take a simple hypothetical with a company that received venture financing. Before the financing, the company had 7.5 million shares of common stock outstanding, including a reserved equity incentive pool. These were issued to (or reserved for) founders, employees, advisors and other service providers.

The company raised $5 million on a $20 million post-money valuation, resulting in the investors acquiring a 25 percent stake in the company. Given the 7.5 million shares of common stock outstanding before the financing, investors were issued 2.5 million shares of Series A preferred stock to achieve a 25 percent ownership, with a purchase price of $2 per share (raising $5 million by selling 2.5 million shares of Series A preferred stock).

The first truism is that the Series A had a value of $2 per share at the time of sale, the price established between willing parties in an arms-length transaction.

Should the common stock also be valued at $2 per share? After all, how else could the company have a $20 million post-money valuation unless all 10 million outstanding shares of stock—common and preferred—are worth $2 per share? In reality, however, the Series A is more valuable than the common. It possesses features, such as a liquidation preference, that enhance its value.

How, then, should the common stock be valued? A venture-backed company typically does not raise financing by selling common stock, so there are generally no arms-length transactions involving those shares. Historically, companies in Silicon Valley routinely used a 10:1 rule of thumb, valuing common stock at 10 percent of the preferred stock price. That no longer holds up due to tax and accounting rule changes that occurred in the early 2000s.

In the absence of trading activity, the most defensible valuation is obtained by engaging a valuation firm to apply established valuation techniques (market, income and cost approaches). Empirical data from these valuations indicate that the per-share value of a share of common stock typically falls in a range of approximately10 percent to 35 percent of the preferred stock value. Many factors influence the value of the common stock, including the terms of the preferred stock’s liquidation preference.

In our hypothetical, it is plausible that a valuation firm would value the common stock at 20 percent of the value of the Series A preferred stock – in our hypothetical situation, $0.40 per share. This would result in a cumulative value of $3 million for the 7.5 million shares of common stock. Adding this to the $5 million value of the preferred stock yields a total value of $8 million.

What then does it mean to say that a company has a $20 million post-money valuation if the value of its shareholdings don't come anywhere near that?

The answer is that the venture capital investor’s "post-money valuation" is not intended to represent the actual current value that a third party would pay to acquire the company or that a valuation firm would likely place on the current value of the business. Instead, it is driven by the investor's belief in likely exit scenarios for the company and the investor's investment criteria. While there are several valuation methodologies used by venture investors, the Venture Capital Method is straightforward and illustrative. In this model, post-money valuation is determined by dividing (1) the projected future sale value of the company (or its terminal value) by (2) the investor's targeted cash-on-cash return on investment (ROI). Targeted ROIs for early-stage investments are typically in the 10x to 30x range. Accordingly, in our example, the $20 million post-money valuation could be justified by a projected sale price of $400 million and a targeted ROI of 20x.

While there are several valuation methodologies used by venture investors, the Venture Capital Method is straightforward and illustrative. In this model, post-money valuation is determined by dividing (1) the projected future sale value of the company (or its terminal value) by (2) the investor's targeted cash-on-cash return on investment (ROI). Targeted ROIs for early-stage investments are typically in the 10x to 30x range. Accordingly, in our example, the $20 million post-money valuation could be justified by a projected sale price of $400 million and a targeted ROI of 20x.

The key takeaway is that the post-money valuation used by early-stage investors sets an FMV for the preferred stock based on the price per share of the preferred stock purchased. However, it does not set a valuation for the entire enterprise for purposes of valuing the common stock.

It is routine for companies to obtain an independent third-party valuation of their common stock following the completion of a preferred stock financing round; however, early-stage companies generally do not secure such a valuation prior to their first round of funding. As a result, these companies are often required to determine FMV on their own in order to issue equity to early key hires. If your company is navigating this situation, you are well served by consulting with experienced corporate counsel, executive compensation attorneys, or tax and financial advisors to discuss best practices for board-level equity valuation in these circumstances.

In sum, startup valuations often serve different purposes depending on context. A post-money valuation reflects a venture investor’s expectations and target ROI—not the company’s current FMV. For tax purposes, FMV must be determined based on recognized valuation methods, and especially for common stock, this value is frequently significantly lower than that implied by post-money figures.

See our related article about Section 83 and the tax rule that every startup founder needs to know related to the acquisition of stock for services.