When a company first launches, there’s little information to signal its value to potential investors, so its stock is essentially worthless. That’s why the price per share of a new corporation with 10 million shares can be as low as $0.00001.
Once you raise your first priced equity round, you have new information that can clarify the value of your company. For example, if you took $1.2M in capital in exchange for 25% of your company, your post-money valuation would be ~$4.8M. Let’s say this 25% ownership is issued to your investors as 3.333 million shares of Preferred Stock at a price per share of $0.92 ($1.2M / 3,333,333). Generally speaking, the value of Common Stock after an early stage financing is about 23% of the value of Preferred Stock. This would value your Common Stock at $0.21 per share.
But, how do you determine the value of your Common Stock a month prior to a financing? What about 6 months before? And why does it matter?
Any advisors, partners or employees who come on board prior to financing will usually receive large considerations ranging from hundreds of thousands to a few million shares of Common Stock. Granting them shares at $0.001 if the Fair Market Value (the measuring stick used by the IRS, as specified in the IRS code section 409a) is $0.10 would create huge taxes and penalties for your employees. At a minimum, there would be a 20% penalty for options issued below the Fair Market Value.
That’s why it’s crucial to know your 409a valuation before you issue stock options. The more information you have about your company’s worth, the more confident you can be that early hires won’t end up burdened by tax penalties.
Imagine a company where the two co-founders each have 4 million shares. Before raising capital, they decide to bring on a third founder-level partner, who will be issued two million shares. The original founders may have the inclination to grant the new founder shares at par ($0.00001) since that is what they had purchased their shares at. However, had the two founders conducted a 409a valuation, they would have learned the following:
- Both founders can command market salaries of $150,000, and have worked full-time on their project for five months.
- Considering their time and forgone salary as a form of equity, that means they have at least $125,000 invested in the company so far (in this case, $150,000 * 5/12 * 2 = $125,000).
- That would make the price per share closer to $125,000 / 10M, or $0.0125 / share.
- Because these shares are highly illiquid, a discount for lack of marketability (“DLOM”) should also be applied.
- Market studies show DLOMs for very early stage startups to range between 40% - 60%.
- Applying a 50% DLOM would result in a price per share of $0.00625 ($0.0125 * (1 - 50%)
- Therefore, the new founder should get a consideration of $12,500 for their 2M shares.
If the original two founders don’t get a 409a valuation and just issue those shares at par ($0.00001), the new founder and the company would be liable for taxes on the discrepancy between that valuation and the more accurate Fair Market Value of $12,500. At a minimum, the third founder would face a 20% penalty on those options, and could be liable for much more. From a cost-benefit standpoint, it’s better to spend $1,000 and ensure your compliance with IRS section 409A than to leave your third founder exposed to a penalty through no fault of their own.
Preferred Return is a tech-enabled financial services firm that delivers audit-proof valuations, fast, and helps businesses stay compliant as they grow. To speak with one of our valuation experts, schedule a call here.