Coauthored by Zach Liermann
You’re a startup founder and you’ve received your first 409A valuation. Why is it so confusing, and how do you make any sense of it?
If you’ve had a 409A valuation performed for an early-stage enterprise, there’s a high chance the report described a “backsolve” method. Even for people with strong finance backgrounds — those who understand traditional valuation methods such as a discounted cash flow analysis (DCF) or a market approach — the backsolve method can be confusing and disorienting.
That’s because the backsolve method relies on option pricing methods (OPM) to infer a value for common shares based on recent financing rounds by the company’s investors.
Allocating equity value
The purpose of a 409A valuation is to determine the per share value of common stock. For startups that are pre-revenue or have negative cash flows, recent financing rounds led by venture capitalists are typically the most reliable indicators of a company’s value.
Inferring the value of a company based on recent transactions is typically a very simple exercise. For example, if an investor contributes $100,000 for a 10% interest in a company’s common equity, the implied value of the firm’s total equity is $1 million (100k / 10% = $1 million). This is the core concept behind the backsolve method.
So why does the backsolve method become so complicated?
When outside angel and venture capital investors decide to invest in startups, they typically do so with hybrid equity instruments such as convertible preferred shares. These instruments reduce an investor’s overall risk. They provide downside protection by having senior liquidation preferences over common equity (like debt), but they can also participate in the upside by converting to common stock.
The presence of these instruments, along with options and warrants, creates a complex capital structure. The instruments ultimately have a dilutive impact on the value of common stock.
Going back to the previous example, if the investor contributes $100,000 for convertible preferred shares, then we really don’t know what percentage interest they have truly paid for. This is because at a sale or IPO, if the sale is high enough, it will be most optimal for the investor to convert to common stock. However, if the sale amount is lower, it may be more optimal for the investor to keep the preferred shares and collect their liquidation preference.
Each of these scenarios ultimately results in a different ownership percentage at sale. Therefore, the investor’s percentage interest at the time they contributed the $100,000 is variable and contingent on the future value of the firm. This contingency on future value is the crux of the complexity typically found in 409A valuations and the backsolve method.
Implied equity value: Backsolve method
The backsolve method solves this contingency issue by modeling the company’s share classes as a chain of call options on the overall equity value. The company’s equity is broken down into a series of “breakpoints,” which is a future value where it becomes advantageous for an investor to convert their securities into common equity. Each breakpoint serves as an exercise price, or strike price, in an option pricing model.
By using option pricing methodology, the payoffs of each breakpoint at every future outcome of equity value, from zero to infinity, is effectively examined.
Figure 1: Option pricing methodology treats share classes as a chain of call options on the firm's equity value. The value needed for share class to convert to common equity = breakpoint
The payoffs at each breakpoint are then probability-weighted and discounted to present value at an applicable risk-free rate. The option value determined for each breakpoint is then allocated to each share class using a waterfall analysis, which examines ownership at the respective breakpoints.
Finally, once the aforementioned process is completely modeled, the overall equity value needed for the most recent financing round to equal its issue price is solved for. Hence, the value has been “backsolved.”
Is your startup using deferred compensation?
If your startup’s compensation plan includes any form of equity or deferred compensation, you need a qualified 409A valuation. The methodology can be complex, and it’s best to get your analysis from an experienced specialist who can provide a reasonable and defensible valuation that will stand up to IRS scrutiny.
Wipfli has the professionals who can provide an effective safe harbor 409A valuation. Learn more about our services in:
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