I get this question all the time from US-based startups: how should we price our Common stock? It’s a very simple question with a not-so-simple answer. The reason is that in the very early days of a startup’s evolution, the methods used to price the company’s stock involve more art than science. Let’s explore further.
(Disclaimer: I am not a licensed attorney and I am not a certified valuation professional. The following information results from my own personal experience and conversations with hundreds of startups. You should ALWAYS consult with your attorney and/or accountant for matters as important as setting your stock price. At the end of this article you’ll see additional comments from a certified professional in the field of business valuations.)
When you incorporated, probably as a Delaware C-corporation, you set a Par Value on your newly-created Common shares. The Par Value is almost never used in practical purposes but is intended to represent the nominal value of the shares and, therefore, the value the company agrees to never go below when selling the same class of shares.
Many startups set the Par Value at a fraction of a penny, like $0.0001 or even as low as $0.00001. If you multiply the Par Value times the total number of issued shares you incorporated with (usually a huge number like 10 million), the implied valuation of the company is still extremely low. Even as low as a few thousand dollars. That probably makes sense for most startups during the very early stages when there is still a ton of risk and they possibly still have no revenue. Even certified valuation professionals take risk into consideration in their formulas.
Par Value versus Fair Market Value
The Par Value and the current Fair Market Value (FMV) of your Common shares are two different things. But in the early days before companies reach some amount of repeatable revenue per quarter, they often leave the two equal. How much can your business grow before you should start to escalate the FMV? It depends on who you ask and how conservative you want to be.
FMV becomes really important when issuing stock options to employees or advisors because the FMV price per share becomes the exercise price for those stock options. Even though early stage startups aren’t much on their radar, the US IRS does not take kindly to companies that issue stock options with exercises prices below what a reasonable FMV is.
Since I want to steer far clear from giving legal advice, I won’t provide any guidelines. Just realize that even once you start to escalate the Common stock FMV, the Par Value almost always remains the same as it was originally set. It is possible that stock splits and other unusual actions will have an effect on the Par Value.
Benefits of a Low FMV
Early stage startups can really benefit from having a low FMV because it means they’re able to issue stock options to new employees with an extremely low exercise price. And since these same employees probably aren’t getting cash compensation anywhere near the market rate (read my related article titled “Compensating Your First Employees When You Are Cash Poor“), granting equity with a low exercise price can be a key selling point. Just do the math on 100,000 shares granted to an employee with an exercise price of $0.0001 per share. It will only cost that employee $10 to exercise the shares after they are vested!
After the startup has success and their FMV is boosted to just $1 per share, a future employee that gets the same 100,000 shares of stock options will be faced with a $100K exercise cost. Big difference.
Convertible Note Valuations are a Different Thing
I sometimes find startups that say they priced their Common shares at something like $0.50 per share because they’re raising a seed round of funding on convertible notes (or SAFEs) with a $5M valuation cap and they are incorporated with 10M issued shares ($5M / 10M shares = $0.50 per share). The math is correct but the logic is not, for two reasons. First, the valuation cap does not set the valuation of the company but rather serves as a future protection mechanism for the investor, in case the company’s Series A valuation is way higher than originally expected (see related article title “Justifying the Cap Amount in Your Convertible Note“). Second, and more importantly, the convertible notes don’t convert into Common stock but rather Preferred stock. Preferred stock has all sort of “preferential” rights, which causes them to be valued much higher than Common stock for the same company. More on that next.
Equity Financing (Discount Derivative Method)
If you raise an equity round of financing in which you sell Preferred shares to accredited investors, those Preferred shares will be priced as a derivative of the company valuation you agree to with the investors. Many startups will re-price their Common shares following such a financing activity and will do so by applying a significant discount to their Preferred share price. I’ve seen discounts in the range of 75-85% but have never seen official guidelines because this is an approach taken from a startup and board of directors that doesn’t feel like a professional valuation is yet necessary. This derivative discount method is also more commonly used for smaller equity rounds of financing in the $1-2M range.
Why the discount? It’s because Preferred stock has many “preferences” or special rights that Common stock don’t have. I’m talking about things like a liquidation preference (first money back), special voting/blocking rights, anti-dilution rights and more. Because of this, Preferred stock is usually considered far more valuable than measly Common stock.
Progress Before an Equity Financing (Thumb in the Air Method)
What about a company that raises more than one round of funding using convertible securities and that enables them to start growing their revenue without raising an equity round of funding? Without a calculated Preferred share price, there’s no opportunity to perform the discount derivative method mentioned above. If revenues have reached a certain point, most experts will suggest having a professional valuation performed. How much revenue is sufficient to trigger this? It’s subjective and revenue isn’t the only factor to take into consideration. I’ll describe more on professional valuations in the next section.
Short of having a professional valuation done, I’ve seen some startups use what I call the “thumb in the air” method. For example, after getting the product launched and reaching $5K in MRR, the company’s board of directors might decide to escalate the FMV from $0.0001 to $0.002. That’s a 20X increase in the FMV but, admittedly, there’s no scientific basis for the higher share price. Basically, the company and their board directors are trying to demonstrate that the company is more valuable and less risky than before but without paying to have a professional valuation done.
Even without an equity round of funding to trigger share repricing, it is strongly recommended to have a professional valuation at some point when your revenues reach something like $25K per month. I’m sure many on the conservative side would recommend doing it much sooner. Possibly they are right. Once you get to $1M per year you almost certainly want a professional valuation done every year. Those valuations will price all classes of shares and protect you against lawsuits or IRS/SEC claims that your stock is underpriced.
Side Note: Although I’ve been using revenue milestones as the potential trigger for changing the FMV of your Common stock, it’s not the only potential trigger – just the most common (no pun intended). Getting a patent approved or something else that could denote a considerable improvement in company value or considerable reduction in death risk could also be triggers.
You can have a local business valuation professional (check their credentials and certifications) do the work or can check out an online service called Carta as an alternative, if you’re willing to forgo the deeper and on-going relationship you can get with a local professional.
How can you determine the level of revenue that justifies valuing your stock the proper way? The answer requires a risk-reward evaluation. With many thousands of startups formed each year, the odds of an IRS audit are extremely low. In fact, I cannot find any cases in which the IRS took action against a startup for violation of their valuation rules. Also, the standard the IRS would apply in such a case is that your chosen valuation was either “grossly unreasonable” or that you didn’t make a “good faith effort” to value the shares. Although that’s a pretty high bar for the IRS to reach, it’s like various forms of insurance. They aren’t in place for what is likely to happen but rather what could happen.
Side Note: The bigger risk with not escalating the FMV of your Common shares as needed over time relates to fundraising and acquisition due diligence. A Series A or Series B investor will want to see that you’ve been running the company by-the-book or close. Sophisticated acquirers will want the same. So my belief is that it’s not the IRS you should be worried about but rather sophisticated investors (ie – VC’s) and big company acquirers.
I also find startups that worry about a professional 409A valuation setting the company’s worth for things like M&A or the next round of funding, but that’s not the case. A 409A sets the stock price for a very specific purpose – tax compliance. It’s also the only sure way to be fully compliant with the IRS, regardless of your company’s size.
Accidentally Jacking Up Your Common Share Price
I sometimes find a very early stage startup with a Common share price of $0.20 or higher. When I ask why the per-share price isn’t still a fraction of a penny, they usually tell me they sold Common class equity to an investor. Oops! It’s true that is an easy way to sell equity to an investor that immediately wants to be on a cap table versus investing on a convertible security (see related articles titled “Convertible Note Basics” and “Reviewing the SAFE Investment Instrument“). But it has a negative consequence of jacking up your Common share price due to the fact that you sold X percent equity for Y investment. That mathematically dictates the share price.
As mentioned above, there is a huge benefit to having a low FMV for your Common shares, especially during the early days of the company when you aren’t able to pay market-rate cash compensation to employees. You’re using equity (stock options) to make up the difference. If your sale of Common stock to an investor causes the share price to jump to $0.20 per share, the next employee you hire will need to spend $20,000 to exercise their 100,000 shares of stock options. And only because of the sale of Common equity to an investor.
A potential solution that I often see used is to create a second class of Common stock for the investors. Their Class B Common shares (for example) would have some special rights attached to them (ie – liquidation preference) and that alone allows you to price their stock using the mathematical formula while keeping a lower FMV for the regular, Class A Common shares held by your employees and advisors.
Side Note: This same situation happens with companies formed as LLC’s but only with Units as the individual element of equity. If you’re an LLC and you need to sell equity to an investor, consider creating Preferred Units for them with special rights versus the Common Units you and your co-founders hold (Class A versus Class B would work the same way).
Here’s another risk. What if you later sell Preferred shares in an equity round of funding (ie – Series A) and the resulting Preferred share price is $0.25? Using either the discount derivative method or a professional valuation will likely result in a Common share FMV around $0.05. Oops! How are your employees with a stock option exercise price of $0.20 going to feel about their stock options now being “under water”! You and your board of directors are going to be faced with a repricing debate on former stock option grants. Believe me when I say that’s going to get the attention of your corporate attorney.
Let’s get back to the title of this article, which relates to pricing your stock in the early days. Although a professional valuation the only fully-compliant method to value your shares after you’ve made any meaninful progress, most startups leave their Common share FMV the same as par value until they launch their product and start generating revenue. At that point they often use the “thumb-in-the-air” method until revenue further escalates and becomes more repeatable/predictable or they raise an equity round of financing. If the funding raised in the equity round is small (up to about $2M), I see a lot of startup boards using the discount derivative method described above to adjust the price of the Common shares (using a discount versus the Preferred share price).
Whichever method is used, the newly-decided FMV becomes the exercise price that is used for stock option grants to new employees and advisors.
Any actions taken related to your stock/unit price must be done in conjunction with your accountant and attorney. And if your attorney isn’t a corporate attorney that understands the startup capitalization and early growth phase well, get one.
– – – – – – – – – – – –
Additional Insights from a Specialist
Special thanks to my friend and former business colleague, Shari Overstreet. At the time of this writing, Shari is Managing Director for The McLean Group’s valuation practice in Austin, Texas. Shari has certifications in accounting (CPA), business valuations (CVA) and M&A (CM&AA). Here’s what she has to add on the subject:
The question of when a company should start having a valuation performed by an expert is the salient point. Of course, the main driver of having a valuation requirement is compliance related, and, quite frankly, fairness, as options and equity interests are considered to be compensation. As Gordon mentions, challenges to valuations come from not only the IRS and SEC (and your accountants), but also appear in shareholder lawsuits for a variety of reasons.
In the old days (not so many years ago), most attorneys recommended having a business valuation expert perform the valuation when a company received their first institutional funding round. However, due to advances in the whole startup ecosystem, the financing requirements and vehicles for younger companies have changed, which means a company receiving its first institutional “A” round is, in many cases, equivalent to one receiving a “B” or “C” round several years ago, in terms of its business plan progression. This makes determining when to have a professional involved in determining the stock price all that much more difficult.
Additionally, as mentioned above, the financing vehicles have and are changing from “simple” preferred rounds to other types of financing, like convertible notes, etc., therefore, making the good old “rule of thumb” approaches not useful.
In all, my advice to a young company is to form a relationship early on with a business valuation firm. Doing so is just as important, if not more important, than having a relationship with an attorney or an accountant, esp. for startups. The reason it is so important is because as an entrepreneur, your potential (lifetime) wealth will come from the equity component of your company. It’s important to get it right. A good valuation expert will likely realize you’re a young company, and will price their work accordingly so they can grow with you. They will also serve as trusted advisers for other topics that can arise and they should work closely with your attorney and accountant.