Valuing Startup Common Stock

23rd December, 2015 No Comments Recruiting , Venture Capital

Over the years, I have had many occasions to talk about company valuations with founders.  Whether negotiating the terms of an investment or discussing option grants at board meetings, the topic is central to the relationship between a company and its closest stakeholders – its shareholders.  But while much has been written about company valuations and the negotiations that determine them, I find that little has been written, and many founders are uneducated, about how to value the common stock and options in their companies.

First, a few reasons why you should care about this topic, peppered with some key information about common stock pricing:

  • Generally speaking, for a company with both preferred and common stock, the value of the latter is less than that of the former.  The values are different because preferred stock comes with rights that the common does not have.  It’s not unusual for the preferred shares to be valued at three times the common price.
  • The price of the common stock is typically the strike price for employee options (which are generally options to purchase common shares).
  • Pricing your common shares incorrectly or at the wrong time (see below) can lead to overpriced (or underpriced) options, tax consequences for employees or the company, and disappointed employees.

Second, given the points above, you should be thinking (a) how do I price my common shares, and (b) when do I price them?

There are three ways to price common shares:

  1. The board of a company agrees to a common share price according to an analysis of the company’s value, declaring that value in writing.
  2. The company hires an accounting firm which conducts a valuation of the company and determines a corresponding common share price; this is called a 409A valuation.  This service generally costs several thousand dollars or more.
  3. The company sells common shares (or issues them in exchange for consulting or advisory services) to an arms-length third party at a negotiated price.

Generally speaking, most companies reprice their common shares (and therefore options) when they raise a new financing round.  Most experienced investors will prompt the company to undertake a 409A at that point to ensure the common shares and options are appropriately priced.

Entrepreneurs need to be careful, though, to consider (re-)pricing the common stock at other points when appropriate.  For example, it can be a good idea to set a common share price after a company is founded and has begun operations, but before it has raised capital from professional investors in a seed financing.  Doing so ensures that employees and advisers who work with the company at this risky stage receive options (or shares) with an appropriately low basis (initial price).  If the founders wait until they raise capital to set the common price, they may be tempted to set a price that is influenced by the valuation of the recent financing, which price is almost certainly higher than is “fair” for employees who joined before the company raised the round.  On the other hand, granting options at the price set for founder shares (the lowest price that the shares are ever likely to bear) is also inappropriate, as employees who come on after the founders are taking on less risk.

For new companies that have not raised capital, in spite of the logic above, it can be tempting to put off a common stock valuation exercise.  You may not want to pay for a 409A valuation or even have a functioning board.  But experienced founders will tell you that it’s worth it to find a way to set a price if you are granting options or shares to employees or advisers.  Those early supporters deserve fair treatment.

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