The magic of pre-IPO valuationsStartups almost never have profit. They are lucky if they have a product, and they rarely have revenue. Despite this, they still need to attract customers, employees, and, most importantly, investors. So how does a new company without obvious market value attract potential investors to keep growing and making money? Startups trade on the currency of their valuation as a proxy for their fair market value. These valuations quantify the current or projected worth of the company, and they can be determined through a variety of different methods. An increase or decrease in the valuation of a startup can have a massive impact on how potential investors, customers, and employees respond to them. For that reason, the company and its investors want the rest of the world to see it with the highest valuation possible.
Because the valuation of a startup is so important to future investors or customers, you might be inclined to think the methodology for valuing a company would be pretty consistent. Unfortunately, the reality can be the opposite. Different methodologies are often used for different companies in different industries, depending on which would benefit the company’s valuation the most. But at least the valuation is shown to investors and customers so they know what they are buying, right? Wrong again. Most companies actually have (at least) 3 different valuations: one for the public, one for tax purposes, and one for the accountants. Each type of valuation has a different purpose and affects companies differently.
The public valuation of a company is – you guessed it – the valuation that the public sees. This is the valuation that is published in news articles and shown in the media, and it is what customers, employees, and retail investors see from the outside. Because this valuation is what everybody sees, the initial investors and their limited partners want it to be as high as possible. There is a wide variety of valuation methods for this purpose, and different methods are used depending on the industry, product, location, or which stage in its development the company is in. Different methods can also be used to make the valuation appear higher. The most widely accepted method for public valuations is the Venture Capital Method, also known as the Post-Money Valuation. This valuation is based on how much investors expect to make if they plan to sell the business or go public after increasing its valuation, and it is commonly shown in the media as “X company raises $Y at a $Z valuation.”
The requirement of a tax valuation for companies was implemented in 2005 by the IRS following the widespread practice of Silicon Valley startups offering stock options as non-cash compensation for employees during the dotcom boom. At the time, non-cash compensation was not taxed by the IRS; employees only paid taxes on the cash compensation. When the non-cash component of the compensation far exceeded the cash component, the IRS realized it was suffering a massive loss in tax revenue. In order to make sure the government is able to get its piece of the pie, the IRS implemented IRC 409a, making it a law for employees to pay taxes on the non-cash component of their compensation, e.g. stock options. In order for the IRS to accurately assess those taxes, all venture companies need to obtain a tax valuation to estimate the value of their stock options. Because the purpose of the 409a valuation is to pay taxes on stock options, shareholders want this valuation to be as low as possible; often it can be 30-50% lower than the post-money valuation.
The accounting valuation of a company is how a venture fund shows what the investment is worth on its books to their investors and limited partners; the investors need to be able to show how the investment is performing on their accounting books as an “unrealized gain” for audit purposes. In 2007, the AICPA developed guidelines for these valuations called ASC 820 (formerly FAS 157). However, as with many things, value is in the eye of the beholder. So, the same portfolio company can be valued differently by different investors, even when using the same guidelines. Since the motivation for this valuation is to show maximum gain for the limited partners, the venture funds want to jack this valuation up as high as possible, hopefully matching the post-money valuation. The problem with that is the post-money valuation assumes that all the warrants, options, common stock, and multiple rounds of preferred stock all have the same rights and terms, which almost never happens.
This is the magic trick of pre-IPO valuations. We have 3 different valuations, with 3 different purposes, calculated 3 different ways; the fair value of the company is probably somewhere in the middle of these 3. But the media, retail investors, and the general public actually only ever see 1 of these 3 – the one that the company wants you to see, the highest one. Companies create an illusion of a certain valuation, hiding the full story from the rest of the world. The higher the public perceives the value of a company to be, the more money venture funds and their limited partners make from their investment, regardless of the fair market value of the company. If the outside world was able to peek behind the veil, the illusion would be shattered and some of the astronomical profits would be brought back down to earth.
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Original source: Inc.