You keep using that word. I do not think it means what you think it means.
This write-up was originally sent to subscribers as a part of our Mission Control weekly insights, a series where we share wisdom and quick breakdowns on topics from our entrepreneur support network.
It’s not uncommon for terms in early-stage startups to be wildly overloaded, but valuation may take the prize for the most confusing to founders. If you’re unsure about the difference between a pre-money valuation, a post-money valuation, a valuation cap, a 409a valuation, and the value of your common stock at any given time, you’re not alone! But, as a founder, it’s worth understanding enough to avoid equity mistakes and to avoid sounding like that guy from The Princess Bride when you’re talking to investors.
What’s the Big Deal? ->
Your 409a valuation has very little do with the valuation or valuation cap you negotiate with investors during a funding round. If you’re using a 409a valuation to explain or justify an investor-facing valuation or even if you’re talking about them in the same sentence you’re probably putting your foot in your mouth.
The Details
In the beginning, your company isn’t worth anything and nobody really cares about that fact—where nobody is inclusive of investors and the IRS. You have one class of stock—common stock—and it is priced as near to $0 per share as realistically possible (think $0.00001). Pricing the common shares close to $0 makes it very easy for founders and early team members to purchase their shares with small cash contributions and limited income tax exposure.
Things stay relatively simple until something happens that places a value on the company or necessitates some negotiation of its future value. For startups, that’s usually the first outside funding.
The first outside funding often comes through convertible instruments like SAFEs or Convertible Notes rather than through a sale of shares of stock. Since shares of stock will not be sold, they don’t have to be priced. Since shares of stock don’t have to be priced, there’s no negotiation of a valuation of the company. Avoiding negotiating a valuation and the other components of a stock sale helps transactions happen quicker, which is mostly good for everyone.
In the absence of a valuation, a smart investor still wants a way to understand and protect the percentage of the company they’ll eventually own. To gain that understanding and protection they negotiate a valuation cap. The valuation cap sets the maximum valuation at which the investment will convert. In other words, the (roughly) minimum percentage of the company the investor will own at the time of conversion.
The valuation cap is negotiated, but it’s a protection of percentage ownership for investors, not a statement of a point-in-time value of the company.
When money starts coming in to a company, it represents an increase in the company’s value. Usually, there’s also some traction or revenue accumulating around the company and pushing that value higher. The money that comes in will often be used to hire the company’s first full-time, W2 employees. It’s no longer arguable that the company is worth effectively $0 and there are now people outside the founding team of the company who care about how much it’s actually worth.
Gust's Mission Control can guide early founders through all sorts of complex startup hurdles, like modeling churn.
The increase in value of a corporation translates to an increase in the price of its shares of stock. As the price of the common stock increases it becomes cost prohibitive for new team members to purchase grants of stock or recognize them as income. So, instead, companies begin issuing stock options—an option to buy shares in the future at a specific price (the strike price).
When a company begins to issue stock options they have to comply with new regulations from the IRS including section 409a of the internal revenue code. To comply with section 409a, a company will typically get a 409a valuation—a valuation by an external firm that establishes a strike price and provides safe harbor from future scrutiny of that price by the IRS. A lower strike price translates to a larger potential future upside for option holders so a lower 409a valuation helps a company incentivize new hires.
If things are going well and the company is achieving early growth and revenue milestones, the next round of investors will be investing a lot more money in a company that has significantly more tangible value. There’s enough at stake and enough information available that both sides are willing to bear the additional cost of negotiating a sale of convertible preferred stock.
During these rounds (the ones that start with Series) the company and its lead investor will negotiate a pre-money valuation of the company. The pre-money valuation is a point-in-time value of the company that may be reasonably tied to the company’s revenue and growth performance but will also be negotiated based on investors’ target ownership percentage. The pre-money valuation will be used to set the price of new series of stock that will be created and sold during the financing transaction. The pre-money valuation + the total new money invested in the transaction = the post-money valuation of the company.
Since the shares sold to investors during these transactions are part of a different class of stock, their share price does not directly impact the share price of common stock. Since the shares sold to investors have additional rights and protections, they are typically and justifiably valued considerably higher than shares of common stock. This allows companies to sell higher-priced shares to investors while keeping the price per share of common stock low to efficiently incentivize employees.
Gust's Mission Control can guide early founders through all sorts of complex startup hurdles, like modeling churn.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.