The funding process through a venture capital investment is rather complicated. Once the idea presented in the pitch is chosen by investors, another very complicated step follows, as venture capitalists decide to valuate the company in order to appraise the value of the equity ownership held by them. This part of the deciding process must be fulfilled as investment plans are very risky due to the early stage of development of the company that needs funding to the innovative character of the products they want to impose on the market and to the fact that the market’s demands cannot be correctly evaluated in such short time. But, this valuation needs to be done in order to establish the percentage of shares investors will receive in return for the invested money. This is the only way in which they can calculate their final returns. Let’s not forget that this valuation is important for the demanding company as well as this is the moment in which their amount of shares is determined.


Stage 1 - Embryonic - No Product and little expense history   

•    No product revenue to date 

•    Limited expense history 

•    Have an idea and possibly some initial product development 

•    Incomplete management team 

•    Seed capital or first-round financing provided by friends and family, angels, or venture capital firms 

•    Securities issued sometimes common stock but more commonly preferred stock (Preferred virtually always convertible to common)

Stage 2 - Early development - Moderate development effort with partial proof of concept 

•    No product revenue (still) 

•    Substantive expense history, product development is under way, and business challenges are thought to be understood 

•    Second or third round of financing occurs during this stage 

•    Typical investors are venture capital firms, which may provide additional management or board of directors’ expertise 

•    Securities issued to those investors are preferred stock

Stage 3 - Later stage development - Product in beta testing 

•    Significant progress in product development 

•    Key development milestones met (e.g., hiring of a management team) 

•    Development is near completion (e.g., alpha and beta testing) 

•    No product revenue (still) 

•    Later rounds of financing occur 

•    Typical investors are venture capital firms and strategic business partners 

•    Securities issued to those investors are typically preferred stock

Stage 4 - Commercially Feasible - First revenues, operating losses 

•    Key development milestones met (e.g., first customer orders or first revenue shipments) 

•    Some product revenue, but still operating at a loss 

•    Usual for mezzanine rounds of financing 

•    Discussions start with investment banks for an initial public offering

Stage 5 - Financially Feasible - Break through to profitability 

•    Product revenue is achieved 

•    Breakthrough measures of financial success such as operating profitability or breakeven or positive cash flows 

•    Liquidity event of some sort, such as an IPO or a sale of the enterprise, could occur 

•    Securities issued typically all common stock, with any outstanding preferred converting to common upon an IPO (and or other liquidity events)

Stage 6 - Established - Meaningful history of revenues or profits 

•    Established financial history of profitable operations or generation of positive cash flows 

•    IPO or sale during this stage

Venture Capital Valuation Overview

In any private equity transaction, the biggest issue is going to be business valuation. In seed round financing, the issue of valuation often becomes even bigger, because normal metrics of valuation, such as earnings and revenue are non-existent. Entrepreneurs often value their company at what they believe it will become. Investors value the company at its current worth.

If, for instance, an entrepreneur made an offering of $1 million in securities representing 25% of the company post-transaction, the offering would value their company, before any significant development, at $3 million (pre-money). Could your idea and your commitment to seeing the idea through really be valued at $3 million?

Within the realm of startups, there are different levels of development prior to revenue: concept, proof of concept/product in development, prototype, product developed.  An idea, no matter how great, is at the earliest level of development, concept.  Most likely, it would be your commitment to seeing an idea through rather than the idea itself that would peak investor interest.  If that commitment were sufficient to spark investor appeal at the concept stage, investors would likely seek an exponential return on investment.

Business valuation in venture capital transactions determines a present value of a future business. The method is called discounted cash flow (DCF) and discounts future earnings and residual business value upon the company's exit to a present value, based on a percentage that accounts for the interest rate the investors could get in a risk free situation plus a risk premium for the endeavor. The risk premium for a startup is high, because of the uncertainty involved and the high percentage of businesses that fail.

Venture capital firms and angel investors who tend to operate like VC firms might want 70+% ROI to account for the risk of investing in a pre-revenue, concept-only idea. The risk comes from the fact that the concept has not been proven to be feasible or useful, its development costs are uncertain, and the ability of the founders to develop it is unproven.  There is also a threat that a more mature company could take the idea and develop it faster than the startup.  The 70% ROI means that a five year plan should include a 14 fold return, requiring a $4 million (post-money) company to become a $56 million company in 5 years. If you approach the investors without any employees or management, or without substantial development, the premium could be even higher. Certain industries will also require a higher risk premium.

Even at the low end estimate (of 40% ROI), your $3 million idea will have to result in a company whose cash flow and residual value at the end of the five years is $21 million.

Not all angel investors will engage in a discounted cash flow analysis to value your business and/or may not require such a high rate of return. Some angels are looking to mutliply their investment by a certain number in a certain number of years. This is essentially a DCF with no defined ROI. There are even some real "angels" out there that will simply like an idea and then decide what they want to put into the company. The corresponding equity stake has little to do with any analysis of future earnings. However, most angels are going to take some look at the risk factors, acquisition prices for similar businesses, and profitability and revenue figures for those businesses, before they sink a large amount of personal capital into your venture.

Negotiating business values is often a disappointing endeavor for entrepreneurs doing their first venture capital transaction. There is some legitimate undervaluation that investors may propose to get a good deal. They are also expecting an inflated valuation, so the plan should reflect that. However, even the "fair" values use a risk premium that challenges the entrepreneur's ability to succeed. Be prepared to support your revenue projections and argue for a lower risk premium to increase valuation, but be prepared to accept a valuation that reflects the risk involved with startup capital if you decide to go the VC route.

Startup Valuation Terminologies

You need to know these two terms.

Pre-money valuation:  venture capital terminology for the valuation given to a company by a venture capital firm before it puts money into it. For example, a start-up is valued on a pre-money basis at $4 million. After $1 million is invested the company has a post-money valuation of $5 million with the venture capital firm owning 20%.

Post-money valuation: valuation placed on a firm immediately after receiving a round of funding.

No negotiating item between entrepreneur and investor creates a wider gulf than this one. The two parties may agree on every other point but will have diametrically opposing views on what the startup is worth and how much equity the investor should receive in exchange for his capital.   To put it bluntly, placing a credible valuation on a startup is impossible. Privately held companies on the sales block are typically valued at a multiple of their historical ODCF (Owner's Discretionary Cash Flow). ODCF is the cash that can go into the owner's pocket after all operating costs are covered for the year. Obviously, since a startup lacks historical ODCF which is the basis for an objective valuation, any opinions expressed on valuation will be entirely subjective.

As a rule of thumb, this is what invariably happens when a startup is seeking seed capital. The entrepreneurs convince themselves based on discounting future cash flows that the company is worth today, say, $5 million. So, since they are looking to raise only $500,000 the investor providing that sum should be happy with 10% of the equity. Then when they start talking with a serious investor they discover that he expects 50 or 51% of the equity for his money. That's the magic number for most angel investors these days.


409A Valuation

What is IRC 409a?


Internal Revenue Code (IRC) Section 409A regulates the treatment of nonqualified deferred compensation (NQDC) paid by a “service recipient” to a “service provider” for federal income tax purposes. Sec. 409A has a measurable impact on the way NQDC plans are designed and operated. Failure to adhere to Sec. 409A could result in immediate taxation, a 20% penalty and potential interest payments to the employee. The context in which most commonly encounter Sec. 409A regulations is related to the issuance of employee stock options and other equity instruments.

It is a common stock valuation.


A 409A valuation is a common stock valuation. Required by Sarbanes Oxley, a 409A valuation is used to value stock options for employees in pre-publicly traded companies. But a 409A valuation is much more than just a required compliance document: it is something that will affect every one of your employees who has stock options—and it’s something that, like it or not, your board members are going to have a vested interest in. Because the 409A valuation is a regulated valuation, there are certain times when it is common to have a valuation done, such as every 12 months or after any significant event. Any time you give employees stock options, you need a 409A valuation. In order to complete the valuation process, you’ll need to gather non-financial criteria, in addition to financial criteria. And, needless to say, accuracy is paramount. You don’t want to find yourself going down the path if you have failed to accurately value your options.

When issuing stock, options,


companies must be aware of the following requirements of 409a:    

1. The fair market value must be determined using "reasonable application of a reasonable valuation method;"     

2. a valuation needs to be performed by someone qualified to perform such a valuation, based on her knowledge, training, experience, etc. (In most cases, companies choose to hire outside appraisal firms to meet this requirement);      

3. and the valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (e.g., new rounds of financing, new product launches, new major customers, etc).

409a Valuation Steps


In order to comply with 409A, a company may hire a third-party appraiser to perform a valuation. This valuation will ultimately be reviewed by several parties, which could include management, Internal Revenue Service, the company’s auditors or even the SEC. The following represents a non-exhaustive checklist of items that you, as a reviewer of the appraisal, may want to consider.

•Is the appraiser qualified?      ◦Does the appraiser have previous experience performing 409A valuations? If not, does the appraiser have significant valuation experience that would suggest his/her competency? Has the appraiser’s work been successfully reviewed by auditors?

•Is the valuation date recent to the grant date?      ◦Is the valuation date no more than 12 months prior to the grant date for the options?  ◦Have any significant events occurred between the valuation date and the grant date that might affect value?  •Is the appraiser employing appropriate methodologies to value the common stock? There are generally two steps involved with this type of analysis.    ◦The first step involves determining the overall company value.    ◦The second step involves allocating the total company value among the various capital owners (e.g., preferred and common shareholders). As outlined in the American Institute of Certified Public Accountants (AICPA) guidelines, the three most commonly used valuation methodologies for the second step are the option-pricing model, probability weighted expected return model and the current value method. Note, the current value method is only appropriate in limited circumstances.

•Does the appraiser support his/her concluded marketability discount using evidence other than quantitative methods?    ◦Many appraisers rely solely on quantitative methods such as put option models to quantify the marketability discount in a 409A analysis; however, IRS will look for evidence beyond quantitative models (e.g., an analysis of restricted stock studies) to support the concluded discount.

•Did the appraiser consider any recent rounds of financing or recent transactions of the company’s common stock?    ◦Has the company had a recent round of financing that it views as arms-length and indicative of fair market value? If so, the appraiser will need to consider the round of financing in the valuation, and may need to rely on the pricing of the round to deduce the common stock value.  ◦The secondary transaction market has grown considerably over the last few years, and private company common stock is increasingly being traded over secondary exchanges or otherwise sold to private buyers. The appraiser will need to consider whether this transaction is a relevant indication of value, which can be driven by factors such as the motivations of the buyer and seller, the block size, the level of due diligence performed and other factors.

•Can the valuation be used for both tax reporting and financial reporting purposes?    ◦If you intend to use the appraisal to support your Accounting Standards Codification Topic 718 stock compensation expense (formerly known as SFAS 123R), the appraisal needs to state that it is valid for both tax and financial reporting purposes.

Primary Factors that influence Common Stock Value


There are a number of factors that impact a company’s common stock value. While the magnitude and directional impact of these factors can vary depending on a company’s capital structure, stage of development, etc., these factors generally have the following impact on value:

•Company Value: Any factor that increases the overall company value (e.g., faster growth or greater profitability) will increase the common stock value.

•Preferred Stock Participation Feature: Most preferred shares contain a conversion option that allows the owner to convert his/her preferred shares into common shares. Some preferred shares, however, have a participation feature allowing them to share in any upside with the common shares without the exercise of the embedded conversion rights (i.e., “they get to have their cake and eat it too”). The presence of this type of participation feature ultimately increases the value of the preferred shares and reduces the value of the common shares.

•Preferred Stock Cumulative Dividends: When a company has preferred stock with cumulative dividends, a larger portion of any sale/initial public offering proceeds will be distributed to preferred stock, thereby reducing the remaining value available to the common stock.

•Sale or Transfer Restrictions: The presence of sale/transfer restrictions associated with the company’s common stock will reduce the stock’s attractiveness and, therefore, reduce its value.

•Control or Voting Rights: In most cases, a single share of common stock does not have significant control or voting rights. The presence of any material control or voting rights will increase the value of the common stocks.

409a Valuation Methodologies


The most viable methods for 409A analyses are conveniently summarized in the AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation (the “Guidance”). While the Guidance had its origin in the financial reporting realm, it provides a good summary of the required considerations in equity valuation for tax purposes such as 409A. The Guidance suggests that the valuation of equity can essentially be viewed from three distinctly different vantage points, any one of which may provide the “best method” based on the facts and circumstances of the subject company or equity. The following sections summarize these methods.

First,    the “current value method” (CVM)    suggests that the valuation of common equity is a function of the company’s valuation as of the grant date. In other words, the CVM essentially answers the question “What is the value of your equity if the company were sold today?” While the Guidance suggests that this method is most relevant when an actual sale of the company is imminent, its use is not exclusively limited to such a scenario.

Second,    the “option pricing method” (OPM)    suggests that the valuation of the common equity can be described as a function of the “optionality” that the common stock has on the future net asset value of the company, given considerations such as senior obligations (debt and preferred equity, for example), estimated time to a sale, and operating volatility of generally similar companies during the interim (which is typically readily observable). In other words, the OPM essentially answers the question “What is the current value of your equity, given your investment horizon, in light of expected operating volatility during the interim?” This method is particularly relevant in cases where there is significant leverage or preferred stock that is senior to the common stock, or it is reasonable to expect future growth in firm operating results and the correlating valuation.

Finally,    the "probability weighted expected return method” (PWERM) suggests that the valuation of the common equity can be described as a function of discrete valuation outcomes for the company in the future. In other words, the PWERM answers the question “What is the current value of your equity if you can roughly estimate the discrete outcomes and probabilities associated with multiple potential sale scenarios in the future?” This method is particularly relevant in cases where there exists an abnormal distribution of future outcomes, with the “boom” and “bust” value(s), and their respective probabilities, being reasonably estimable.   The use of any of these three valuation methods may be appropriate based on a company’s individual facts and circumstances, and a third party valuation of the stock option shifts the burden of proof to the IRS. In times of economic downturn, many companies adjust their compensation structure to include more stock or incentive based compensation. Before you enter the incentive compensation arena, make sure you plan for the tax consequences.