Running a startup comes with a whole host of challenges, responsibilities and legal requirements. One important equity-related concept that founders need to grasp is fair market value (FMV) – an estimation of the current value of an illiquid security that is taken into account when awarding equity to employees and other service providers.
This article explains how private company valuations work and when you might need one, especially if you’re using equity to attract, motivate and retain talent.
What is a company valuation?
A company valuation has different meanings depending on the context. For the purpose of equity compensation, a valuation is typically used to determine the present value of a company’s ordinary share class.
Having an accurate, up-to-date valuation is important for compliance with share plan regulations in a particular tax jurisdiction. For instance, a 409A valuation is needed to issue equity to US workers, whereas granting EMI or CSOP options in the UK requires an HMRC valuation. In the event of an audit, both the company and its employees could face tax penalties for incorrectly valued securities.
How do private company valuations work?
Private company valuations are typically performed by analysts at accountancy firms, law firms or equity management providers. Based on information provided by the company – including its specific circumstances (e.g. funding stage), financial history, projections and cap table data – an analyst will determine the most appropriate valuation method or methods to apply.
Valuation methods
There are a variety of valuation techniques that can produce different results. Analysts often combine several methodologies in a single valuation report to find the overall equity value of a company. This is the total value that equity holders would have a claim on (i.e. if the company was sold), excluding any outstanding liabilities – such as bank debt or convertible notes – that are not counted as equity in the analysis.
Common approaches to valuing a private company include, but are not limited to:
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Precedent transactions – if the company in question recently raised a funding round, this method takes into account the sale price (per share) of its preferred or ordinary shares.
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Comparable company analysis (“comps”) – by applying a revenue multiple based on public companies in the same industry, this method produces a relative, market-based value.
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Discounted cash flow (DCF) – this model takes the company’s projected cash flows for the next 3-5 years, then applies an appropriate discount rate to find the present value of the expected cash flows.
Using a valuation to price equity
After calculating a company’s overall equity value, analysts can then apply an allocation model to isolate the value of a specific share class, based on the terms and rights attached to the shares. For instance, certain assumptions and external factors – including the price of a recently sold preferred share, the expected term of an option grant (or predicted time before a company exit), the risk-free rate of return and market volatility – can be input into the Black-Scholes model to determine the current market value of the company’s ordinary shares. This information can be used for a particular purpose, such as issuing equity to employees at a fixed price per share (i.e. the “ strike price” of an option grant).
Valuations for employee equity
The way you leverage equity is likely to evolve as your business grows, so it’s useful to understand when and why you might need a particular valuation. This depends on where your company and its employees are based and which share scheme or schemes you’re using.
Being aware of the requirements of each valuation type – such as when they expire and whether you need approval from a local tax authority – will help you stay compliant when setting up and managing an employee share plan. We’ve outlined some of the most common valuations for equity compensation below.
409A valuations
A 409A valuation is an independent appraisal of the fair market value of a private company’s ordinary shares. This valuation is based on guidance and standards established in section 409A of the IRS’s Internal Revenue Code (IRC).
If you plan to offer equity to employees or advisors who are US citizens – and are therefore subject to US tax law – it’s important to have a 409A valuation for tax compliance.
→ Find out what you need for a 409A valuation and why safe harbor is so important
EMI & CSOP valuations (HMRC valuations)
When setting up a government-approved share scheme in the UK – such as EMI (Enterprise Management Incentive), CSOP (Company Share Option Plan) or SIP (Share Incentive Plan) – it’s best practice to have an HMRC-approved company valuation before you start issuing options to employees. This process, known as pre-clearance, helps ensure that your company and its employees can take advantage of the tax benefits these schemes have to offer. For instance, eligible EMI options are only subject to 10% capital gains tax (CGT) at the point of sale.
Regardless of whether you’re issuing EMI or CSOP options, your company valuation will be performed (and approved by HMRC) in the same way. However, these schemes differ in how they operate and who qualifies.
→ Get more information on how HMRC valuations work and when you might need one
Growth share valuations
If your company has outgrown UK government-approved share schemes like EMI and CSOP, you might want to consider using growth shares to reward and incentivise your employees.
Before granting this type of equity, you need a growth share valuation to determine the market value of the shares and a valuation hurdle. This hurdle sets the threshold above which growth shareholders would benefit from a liquidity event.
Unlike EMI and CSOP, HMRC pre-clearance doesn’t apply to growth shares. Without a watertight valuation in place, you risk incurring tax penalties for your employees if HMRC decides to challenge the strike price at a later date (e.g. during an audit).
BSPCE valuations
Most French startups are familiar with BSPCEs, or bons de souscription de parts de créateur d’entreprise, but it’s less widely known that international companies (if eligible) can also benefit from France’s most popular share ownership scheme.
Obtaining an accurate BSPCE valuation before granting BSPCEs will help you determine a strike price – including any applicable discounts – that can be justified in the event of an audit by the tax administration. Given the tax penalties and potential fines your company and its employees could face as a result of incorrectly valued BSPCEs, it’s essential to find a valuations provider you can rely on.
→ Read about the tax advantages of BSPCEs and why it pays to have an expert valuation report
Valuations from Carta
Whether you want to issue equity to employees in the UK, US, France or elsewhere, choosing a single solution for both cap table management and company valuations can save you time and money.
Carta is a leading equity management and valuations provider globally, trusted to perform over 15,000 valuations every year. Our in-house experts leverage your company’s data to deliver an accurate report, in line with the requirements of your share scheme and local tax authority. You can then issue the corresponding securities, such as EMI options,through the platform, with all the changes reflected on your cap table in real time.
We combine best-in-class software with industry expertise to deliver valuations faster and for less than traditional providers. Speak to a member of the Carta team to learn more about our services and find a package to suit your company’s needs.
