Startup Legal Talks (8)
How is valuation/stock value determined? Valuation is also required to issue options to employees? How does a VC determine a startup's valuation? What is 409A?
More dry goods, less verbose, welcome to the law of startups. In the previous issues, we introduced several common employee compensation incentives. Many audiences came to ask me no matter which incentive method, how should the value of the stock be determined? Another question that some startups also consider when they are about to raise funds or be acquired is how much is my company worth? In this issue, we will talk about the company's valuation.
The valuation price of a listed company can be queried on the stock exchange at any time, and how to determine the valuation of an unlisted company is indeed a difficult problem. Before introducing how to determine a company's valuation, let's list several common misconceptions about valuation:
Myth 1: The company's valuation only needs to look at a few parameters on the financial statements. This is wrong. There are many factors that affect the valuation of a company. The financial statements of a technology company may not be as good as those of a small hotel, but they can be dozens or hundreds of times higher than the valuation of a small hotel. For a company that provides services, changing the charging model to a subscription system with the same financial data can significantly increase its valuation. As competition in the same industry becomes more intense, even if there is no change in the situation of a company itself, the valuation will fall. Bringing in an experienced manager can boost the company's valuation, whereas a serious scandal involving one person in the original management team will lower the company's valuation. Knowing these fragments, presumably everyone will not think that a financial statement can be used to obtain a company valuation.
Myth 2: A company has no valuation without financing. This is wrong. Some founders will say that our company has been losing money since its inception, and we have never received financing. The price of options to employees is directly zero, right? No, as mentioned earlier, the valuation is not just the numbers on the financial statements. Even if the company has been established for a year, there has never been any account transactions. It is the founder who is looking for resources and designing products alone. The company's valuation Still growing, even if the founder asks a lawyer to build a relatively complete legal structure for the company, it will increase the company's valuation. For example, in one year and one day, the company received an investment of 10 million, and the investor gave a valuation of 50 million. It is not that the company’s valuation was always zero for 365 days, and on the 366th day, the valuation suddenly became 50 million, but the valuation continued to grow in the previous 365 days, but the specific number of the valuation was learned on the 366th day.
Myth #3: A company's valuation is an absolute value, and it's the same no matter who I ask to come up with. This is also wrong. The possible factors I mentioned earlier will affect the company's valuation, and there is no absolute way to calculate the valuation, so different appraisers will design different financial models according to each company's situation, even at the same time. Looking for two different evaluation agencies to evaluate, the evaluation results will be different, of course, the difference will not be too big.
Misunderstanding 4: You can set a random number for the valuation first, and then make up for the problem later. This is wrong. From the points I mentioned earlier, you should have also discovered that the company's valuation is related to many comprehensive factors. Although we can look at the records of the past few years in the financial statements, such as market conditions, Models and management teams have changed over time and are difficult to trace back, so when you find an appraiser to do a valuation, the appraiser can only make the current valuation, instead of telling the appraiser, "You give me Do my company's valuation in 1999."
Myth 5: Lawyers or accountants can also do valuations. This is wrong. First of all, like our lawyers who do paper work, we really don't have much clue about numbers. Looking at accountants again, it seems that everyone feels that accountants should be able to help them come up with valuations. But in fact, the accountant will only calculate the book value of the company, and as mentioned earlier, the book value is only a very small reference standard in the company's valuation, and more is the value that is not reflected in the book. Also, even if your lawyer or accountant happens to have expertise in company valuation, don't ask them to do your company valuation because of conflict of interest. Even if your lawyer or accountant is not selfish, the valuation they make is likely to be considered to be made from a financial model designed from the perspective of your company, and the fairness will be greatly reduced.
Knowing so many misunderstandings, how is the company's valuation calculated? This does not belong to the professional ability of lawyers, nor can it be calculated by a formula, so I cannot tell you the answer. But I can give you two general directions:
The first is that if your company is going to issue options to employees, it is strongly recommended that you do a 409A valuation. Why? Because when the company issues options to employees, there will be a considerable incentive to motivate employees with extremely low prices, resulting in the exercise price of the options being much lower than the fair value of the company's stock, which is also a major part of the investigation by the IRS, and Once found, the penalty is very severe. 409A is a valuation process. In this process, the appraiser needs to understand all the conditions of your company. Basically, it is to turn your company over to the bottom, and the fee is definitely more expensive than your annual financial report. But this money can’t be saved. Once, a company was fined $4 million because the IRS found that the price of options to employees was too low.
The second direction is when the company takes VC financing or is acquired, or when one of the shareholders transfers stock. These big cases that sound relatively more formal are not too much of a problem if you don’t go to an appraiser for valuation. why? Because when the company issues options to employees as mentioned above, the company and employees have basically the same position on reducing the exercise price, so there is a high probability that the price may be very unfair. When it comes to financing, mergers and acquisitions, and equity transfers, the two sides are actually opposites. Unless the buyer or investor is your own father, the price will be relatively fair with high probability, which is called arm length transaction in American law. At this time, the possibility of the stock price going wrong is very small. In fact, I can tell you an example. When a VC determines the valuation of a company, it usually means to first determine how much money the VC has to invest in the startup company, and then negotiate with the startup company for a percentage of shares, and then launch it back to start a business. The valuation of the company, no VC will really spend a lot of money to find an appraiser to assess the value of the company. That’s why we often joke that VCs determine the valuation of a startup, and that’s all determined by the VC’s partners having breakfast with the startup’s founder.
Well, I learned so much about valuation today. When I hear about valuation next time, the founders of the company should not go to their financial statements or check the calculation formula of the company’s valuation online.
More dry goods, less wordy, here is the law of startups, see you in the next issue.
