409(a) Valuations: What Business Owners Need to Know
When it comes to valuing a business, especially in the context of compliance and strategic planning, the process can get complicated quickly. Recently, a client of ours at Eight One Partners reached out after receiving a 409(a) valuation through Carta, a popular cap table management platform. The insights we gained from this experience can be valuable to any small to medium-sized business owner navigating the world of valuations, particularly when it comes to understanding how industry classifications impact these evaluations.
The 409(a) Valuation Process: A Quick Overview
A 409(a) valuation is predicated on fair market value and is usually executed to substantiate the value of equity grants. This is particularly important for tax compliance and setting strike prices for stock options. Platforms like Carta utilize mathematical models, incorporating a substantial amount of transactional data, to generate these valuations. They are especially popular in the startup world, where accurate and compliant cap table management is crucial.
The Complexity of Industry Classification
One interesting aspect of these valuations is how Carta will classify the client’s industry. Industry classification can be tricky because it significantly impacts the multiplier applied during the valuation process. A multiplier is essentially a factor that represents how companies in a specific industry are valued relative to their financial metrics. If your company is misclassified, it can either inflate or deflate its perceived value.
We encourage companies to challenge Carta to provide alternative valuations based on different industry classifications. While an industry can describe some level of risk, an industry does not describe a business model. The results can be surprising, some multiples will put the valuation closer together than one might think while others can change the story.
Why Common-Size Financials Might Matter More
While industry classification plays a role, I often find it more insightful to focus on a company’s common-size financials rather than strictly adhering to industry benchmarks. Common-size financials express each line item on a financial statement as a percentage of a total figure, such as revenue or assets. This approach helps normalize financial data, making it easier to compare companies across different industries or sizes.
For example, in the manufacturing industry, you might expect the cost of goods sold (COGS) to range anywhere from 40% to 65% of revenue, depending on whether the company handles manufacturing internally or outsources it. By focusing on these percentages rather than rigid industry classifications, you can get a clearer picture of a company’s operational efficiency and financial health against other players in the industry.
The Dangers of Over-Reliance on Industry Comparisons
One key takeaway from this experience is the potential danger of relying too heavily on industry comparisons when valuing a business. Industries are broad categories, and many companies don’t fit neatly into a single classification. For example, a business might be involved in energy production but also have significant real estate holdings, or it might be classified as a technology company while its revenue model more closely resembles that of a service provider.
This is why it’s essential to look beyond industry classifications and consider the unique aspects of your business.
Ask yourself:
When I describe my industry to a friend out of the know, do they understand what my business does?
Are your cash flow risks similar to that of the industry as a whole?
Are there other industries that might provide a more accurate comparison?
409(a) Valuations and Common Stock Value
Another common question that arises during 409(a) valuations is why the common stock value is often significantly lower than the value of preferred stock or convertible debts. The answer lies in the payout hierarchy during liquidation. Preferred shareholders and debt holders get paid out before common shareholders, which means that common stock typically holds less value unless the company reaches a level where all stakeholders are valued equally. This often takes a long time, particularly for startups.
In our client’s situation, the team involved were experienced investors who understood these nuances, so there wasn’t much concern over the difference in valuation between common and preferred shares. However, for those unfamiliar with these concepts, it’s important to recognize that this difference is a standard part of the valuation process and not a sign of anything unusual.
Conclusion: A Valuation Is More Than Just a Number
Valuations, particularly 409(a) valuations, are crucial for both compliance and strategic planning. However, they are only as accurate as the data and assumptions that go into them. Understanding the impact of industry classification, focusing on common-size financials, and recognizing the inherent differences in stock types can all help you gain a clearer understanding of your company’s true value.
At Eight One Partners, we’re here to help you navigate these complexities, ensuring that your business is valued accurately and fairly, so you can make informed decisions about its future. If you have questions about your company’s valuation or need assistance with financial planning, don’t hesitate to reach out.
