We frequently are asked why the company value in an IRC 409A valuation report is different from – and usually lower than – the post-money value of a venture capital round.
While a post-money value is a helpful back-of-the-envelope calculation for negotiation purposes, it is not the best measure of company value for IRC 409A purposes. Post-money valuation calculations are simplistic and they assume that preferred stock and common stock have the same value. On the other hand, the tax and accounting regulations governing IRC 409A / ASC 718 valuation reports require that we use a more complicated methodology which treats the preferred stock and common stock differently.
This is because preferred stock and common stock have different values. Just ask yourself which you would rather own or which a venture capital investor would pay more to purchase. Preferred stock has liquidation preferences, the power to block financings or sales, and the ability to withhold approval of any new series or shares of capital stock. Common stock does not have these advantages and therefore, is less valuable.
Because preferred stock and other classes of securities (common stock, stock options, etc.) have different rights, we model these differences using a Black-Scholes option pricing model. Our model assumes a variety of different liquidation scenarios – from zero to a large value – and pays off the various securities according to their priority in liquidation for these different scenarios. This approach properly factors in the liquidation preferences of preferred stock and has the effect of lowering value of the company and the common stock.
It should be noted that the valuation methodology used to value a company’s common stock in compliance with IRC 409A / ASC 718 is only applicable to the issuance of stock options and should not be used for transaction purposes (such as a financing, merger, or acquisition).
© Teknos Associates 2014
This article originally appeared in a Teknos newsletter on April 9, 2014 and is reprinted here with permission.
Jim Timmins, Managing Director, 650.330.8801, jtimmins@teknosassociates.com
Jim Timmins heads the valuation practice at Teknos Associates. He has worked in Silicon Valley for more than 30 years, in business valuation, venture capital investing, and investment banking. Jim has provided more than 1,500 business and intangible asset valuations and fairness opinions and has participated in numerous merger transactions, private placements, and public offerings during his career. Jim is an Accredited Senior Appraiser in both business valuation and intangible assets. He can be reached at 650.330.8801 or jtimmins@teknosassociates.com.
Teknos Associates
Teknos Associates provides valuations and fairness opinions for technology companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards.
Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services. However, nothing in this communication may be taken to represent the official position or policy of the IRS. The opinions expressed herein are those only of Teknos Associates.
IRS Circular 230 Disclaimer: Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein. © Teknos Associates 2014
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Teknos Associates. This work reflects the law at the time of writing.