Understanding your startup’s 409A valuation and the backsolve method
- The backsolve method is central to early stage 409A valuations and is commonly used when startups issue preferred shares.
- With option pricing and backsolve methods, each class of equity is modeled as a call option on the company’s total equity, allowing valuers to allocate value across complex capital structures.
- The backsolve method anchors value to real transactions, making it especially useful for fast growing startups with limited financial projections.
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 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.
Here is an overview of these methods to help you understand your 409A valuation:
What is the backsolve valuation method?
The backsolve valuation method is a technique used to value privately held companies that have issues preferred shares. It is widely used in 409A valuations, ASC 820 fair‑value reporting and venture‑backed equity valuation.
What is an option-based valuation method?
The option pricing method (OPM) is the underlying valuation framework used to allocate a company’s total equity value across its various share classes.
With the OPM:
- Each share class is treated as a call option on the company’s equity.
- Liquidation preferences and conversion features are modeled as option strike prices.
Overall, the OPM is the valuation model, and the backsolve method is the technique that uses that model to infer the company’s total value when a recent financing price is available.
How does the backsolve method work?
The backsolve method uses OPM, but in reverse.
Instead of supplying the total equity value, the backsolve method starts from the known price of the most recent preferred financing round. It then iteratively applies OPM to find the total equity value that makes the modeled value of that preferred class equal its actual transaction price.
Once that match is found, the resulting total equity value is used within OPM to value all other share classes, including common stock.
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 OPM backsolve valuation 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.
Modeling total equity value using the backsolve method
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.
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, are 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 the 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.”
What are the advantages of the backsolve method?
The backsolve method offers several important benefits for startups:
- It leverages real transaction data: Because the backsolve method is anchored to the price paid by investors in the most recent financing round, it incorporates actual market evidence rather than hypothetical assumptions.
- It works well when financial projections are limited or unreliable: Early startups often lack stable revenue, cash flow forecasts, or comparable market data needed for traditional valuation methods like DCF or market multiples. The backsolve method sidesteps this challenge by focusing on investor behavior rather than financial predictability.
- It reflects the economic rights of different share classes: Most venture-backed companies have complex capital structures with preferred shares that include liquidation preferences, conversion rights and participation features. The backsolve method captures these rights quantitatively by using OPM, resulting in a more accurate allocation of value between preferred and common equity.
- It is particularly suited for fast-growing, venture-backed companies: Startups experience rapid changes in value between financing rounds. Because the backsolve method updates the total equity value using the most relevant transaction data available, it provides a snapshot that reflects a company’s current stage and momentum.
- It creates consistency across reporting needs: Since the backsolve method is also used in ASC 820 fair value reporting, companies benefit from having a single, coherent valuation approach across equity compensation, financial statement reporting and internal planning.
Is your startup using deferred compensation?
If your startup’s compensation plan includes any form of equity or deferred compensation, you may need a qualified 409A valuation. Wipfli’s valuation team has experience with complex methodologies and can provide you with a reasonable, defensible valuation. Explore our valuation services to learn more about how we can provide you with an effective valuation.
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