So You Need a Valuation? Why? What’s the Purpose?
There are lots of reasons for a privately-owned business to consider a valuation. These might include:
- Pricing employee stock options
- Shareholder buyouts
- Internal sales and purchases
- Buy/sell agreements
- Estate planning and gifting
- Fund raising from potential investors
- Merger and acquisition activity
SO GET ONE!
At first it would appear simple. Hire a qualified professional valuation expert and have a valuation done. But, first why are you getting one done. Do you have a stock option plan and want a “409A Valuation” to provide a fair market value base for pricing stock options. Or, are you trying to sell equity and raise additional capital? Or you want to set up an internal buy/sell arrangement so that partners can buy out partners. The objectives are not the same and the valuation approaches may well differ. In fact the best approach may be to determine an “acceptable” formula that can be used on an ongoing basis for, say, a buy/sell agreement.
Let’s take the stock options issue for example. You have decided to set up a stock option plan and want to issue options. You hire an attorney to write the plan and a valuation expert to determine how to price the options. The expert determines that the company has a fair market value of $500,000 or $3 per common share which can be used to price the stock options. And, like a lot of options, they vest over a 4 year period and the appropriate costs are recorded and amortized over a 4 year period in the future.
At the same time, management decides that it needs to raise additional capital. Do they need or even want to use the same valuation. Maybe not! It can be a starting point, but management may have strong motivations and reasons for seeking a higher share price for funding purposes. They may want to take a more aggressive and optimistic approach to forecasting the future results than was used in the 409A valuation. The company can minimize dilution with a higher price. The purpose is different and there will be a negotiated price. Also, the new investors may want preferred stock, more control, more rights, etc. That can influence the agreed investment value as well.
Valuations are important tools available to management, but the purpose and objective of the valuation needs to be carefully discussed and determined up-front. The need for a 409A valuation, for example, is really driven by tax considerations which protect both the company and the recipient of the stock options. The valuation approach is frequently based on the AICPA practice guide. There may well be a more optimal approach for fund raising, setting buy/sell agreements, etc. One size really doesn’t fit all. As companies go this road they should consider getting professional assistance early in the process. Doing so will enable them to avoid costly mistakes.
Ed O’Dea is a former CFO/COO with significant experience in general and financial management, debt & equity financing, mergers and acquisitions and strategic and financial planning with particular emphasis in the start-up environment. He has a solid understanding of all corporate functions from sales and marketing, to human resources and accounting and reporting which he adeptly applies to the solutions and counsel that he provides his clients. Ed serves as the Valuations and 409A Practice Lead.