Raising capital is a pivotal moment for startups, but valuation often leaves founders puzzled, with questions like “How much equity should I give up?” and “How do I balance my desire for a high valuation with investor expectations?” To make matters worse, valuation discussions can take on a complexity that makes Infinite Jest look like a children’s storybook by comparison.
This blog series breaks down three critical aspects of startup valuation to help founders set realistic expectations and make smarter decisions as they grow.
In today’s post, we’ll unpack the difference between 409A valuations and fundraising valuations. In part two, we’ll explore how convertible debt and SAFEs factor into fundraising. Then, in part-three we’ll wrap things up with a dive into pre- and post-money valuation—and what it all means for dilution.
The Difference Between 409A Valuation and Fundraising Valuation
Startups must navigate two distinct types of valuations: 409A valuation and fundraising valuation. Though both assign a dollar value to a company, they serve different purposes and can vary significantly.
409A Valuation: IRS Compliance and Employee Benefits
A 409A valuation is an independent appraisal of a private company’s fair market value (FMV), required by the IRS for tax purposes. It determines the strike price for employee stock options, impacting both tax compliance and employee incentives. Requiring the valuation aims to prevent companies from granting stock options at artificially low exercise prices, sometimes known as “cheap stock”.
Within reason, a company will target a conservative 409A valuation because it results in a lower strike price, allowing employees to exercise their options at a cheaper cost. To justify a somewhat measured valuation, 409A appraisals use conservative methodologies and apply discounts to account for illiquidity and lack of marketability.
Within reason, a company will target a conservative 409A valuation because it results in a lower strike price, allowing employees to exercise their options at a cheaper cost.
Key Characteristics of a 409A Valuation:
- Conservative: Incorporates comparable company analysis and is also partly based on historical financial performance.
- Preferred vs. Common Stock Differences: The 409A values the company’s common stock, on which employee stock options are based. The common stock lacks certain investor protections that are granted to preferred shares bought by investors.
- Discounts Applied: Discounts for lack of marketability and other potential factors that make shares harder to sell can also lower the 409A valuation.
Why a Lower 409A Valuation Matters for Startups:
- Affordable Stock Options for Employees: A lower strike price increases employees’ potential upside.
- Improved Employee Retention: Employees who perceive stock options as valuable are more likely to stay with the company long-term.
- IRS Compliance: The IRS scrutinizes valuations that are too low relative to recent fundraising valuations, suspecting companies of artificially suppressing FMV to grant options at an unfairly low price.
Fundraising Valuation: Balancing Growth Potential and Investor Expectations
A fundraising valuation is the valuation agreed upon between the startup and investors during a financing round. Unlike a 409A valuation, fundraising valuation is market-driven and reflects investor sentiment and deal terms.
Unlike a 409A valuation, fundraising valuation is market-driven and reflects investor sentiment and deal terms.
Founders are motivated to maximize this number, as a higher valuation allows them to sell the same % equity for more money. Conversely, investors seek a lower valuation so that their dollar investment buys them a larger % equity stake. Founders should be prepared, because investors will typically come to the negotiating table having done significant due diligence.
As far as amount, a very common guideline is to raise enough capital to fund operations for 12 to 18 months, often coinciding with or tied-to milestones that increase the company’s valuation. Needless to say, raising too much too soon can lead to excessive dilution (more on this in part-three).
Key Characteristics of a Fundraising Valuation:
- Growth-Focused: Investors consider future revenue potential, competitive positioning, and scalability.
- Market-Driven: Influenced by investor sentiment and deal dynamics rather than formal methodologies.
- Preferred Stock Pricing: Investors typically receive preferred shares with rights like liquidation preferences, influencing valuation.
Strategic Considerations for Founders (and the Risks of Overvaluation):
Founders must balance the desire for a higher fundraising valuation with realistic growth expectations and a keen awareness of potential future funding rounds. While maximizing the fundraising valuation is desirable, it must align with market realities and long-term company goals.
Crucially, an excessively high valuation can set the company up for a “down round” in future financings. If the company fails to meet the lofty expectations implied by the initial valuation, subsequent investors will demand a lower price, leading to:
- Reduced investor confidence and potential difficulty in raising further capital.
- A negative impact on employee morale, especially for those with stock options.
- Potential strain on relationships with existing investors.
- The possibility of significant dilution for common stockholders due to liquidation preferences. These preferences give preferred shareholders the right to get paid first if the company is sold for less than its last valuation. They typically receive a set amount—eg, 1x their original investment—before any money goes to common stockholders. This can leave little or nothing for common shareholders.
Valuation is a strategic decision that impacts everything from employee morale to future fundraising. Understanding the difference between 409A and fundraising valuations helps founders strike the right balance between compliance, motivation, and growth. To build a sustainable company and avoid the risks of overvaluation, founders should aim for a valuation that reflects both current performance and realistic, optimistic growth potential.
In next week’s post, we’ll explore the world of SAFEs and convertible debt—what they are, how they work, and how they can affect your valuation and ownership down the line.