Shaking Hands in Meeting

Leaders of start-ups need to answer some tough questions before they dive in too deep. What milestones do you need to achieve to create value? What is your business worth today?

Preparing for transition

The Value of Valuation for Start-Ups

  • Travis Chamberlain
  • 6/11/2019

You’ve decided to start a business. Maybe you are seeking capital or you would like to incentivize key employees by offering equity in the business. The valuation of a business in the start-up phase can be challenging, because the future is uncertain and often full of risk, reward, and opportunity.

Build a solid foundation for your start-up

Leaders of start-ups need to answers some tough questions before they dive in too deep. What kind of equity structure will attract capital? What structure will incentivize employees? How do you fairly allocate risk and reward? What milestones does your company need to achieve to create value? What is your business worth today?

Few people can answer these questions alone. The answers will require you to thoroughly articulate your strategy and goals, so that you can provide information and insight to the others that you will bring along with you on your entrepreneurship journey.

A complex valuation case

The following true story demonstrates some of the valuation resources required in the early stages of a business.

The founder of a software company located in the Midwest approached CLA about starting a program to offer stock options to employees. At this early and critical stage of the company’s development, the founder was focused on building an innovative software product, creating a solid company culture, and motivating his employees toward an upcoming product launch. He needed some support to be able to develop the stock option program.

The company was already in the midst of a preferred financing capital raise and planned to grant common stock options to key employees. But the founder was concerned about how to fairly price the options. At that time, the only cash transactions in the company’s equity were for preferred shares, which carried a premium price given their liquidation preference ahead of the common shares. He wanted the common share option strike price to be fair. He also wanted to use the options as an incentive for the employees to invest with the company for the long term.

The company still faced significant risks in terms of its development, and a successful exit through the sale of the company to a strategic investor was not expected for another three years. In the meantime, the company expected to burn through significant cash and would need to raise additional capital. The employees receiving the stock options would have no way to realize any value for their options until and unless there was a successful exit.

Given the company’s cash constraints, stock options were considered a way to provide an incentive and reward the company’s employees in lieu of higher cash compensation. But pricing the options was not straight forward. On one hand, if the options were priced too low, the employees could be subject to significant tax penalties under 409A. On the other hand, if the options were priced too high, the employees would not be fairly participating in the increase in the future equity value, which could be a disincentive. Determining a fair option price was complicated because the company now had two different classes of stock, preferred and common, which carried different rights and preferences. The founder needed some help with this complex situation.

Using the appropriate valuation resources

CLA has a deep understanding of the software industry and a wealth of experience with valuations in complex stock transactions. We worked with the founder to understand the company’s goals and his personal objectives. We helped him understand the valuation metrics in the software industry and the framework for valuation of common stock in a complex capital structure. CLA also provided the company with a 409A valuation, which is fair market valuation documentation for the IRS. That helped the founder determine an equitable way to incent his key employees, and help the option recipients avoid unwanted tax penalties.

CLA’s valuation assisted the company in recording stock compensation expense in its financial statements. This initial valuation also served as a solid foundation for future valuations.

How we can help

CLA can assist you in understanding the value that you are creating in your newly formed company, even if you need to use complex financial instruments. We use a thoughtful, objective, and industry-focused approach and help you to achieve your goals as you move from concept to growth. Our resources and experience can help you build the enterprise you envision.