If you’re a founder or startup employee, you have probably foregone a comfortable position with a big salary in favor of long hours for little pay to build a company you’re passionate about. From a financial perspective, you’re making a bet that, in the end, you’ll be able to sell your stake in the company for a life-changing amount of money that will more than compensate for the wages you could have earned elsewhere.
Given that, it’s a valid question for you (or your partner) to ask: “So, what is my startup stock worth?”
This article attempts to answer that question. The discussion points on taxes should also help you understand general principles. However, every situation is unique, so please consult your tax advisors to understand what’s best for you.
FMV v. SMV
There are (at least) two answers to this question: How much is my startup stock worth?
- Fair Market Value (FMV). Fair market value is the accounting value of the shares. This price is set in accordance with IRS guidance, usually through a third-party appraiser process known as a 409A valuation [Link to: What do startup founders need to know about a 409A?]. The FMV of a share of common stock in the company is set at the time of issuance. This is the price that matters for tax purposes.
- Secondary Market Value (SMV). Secondary market value is the price that you could (theoretically) sell your shares for on the open market. The SMV is a negotiated price at the time of sale. This is the price that matters when you are looking to sell your stake in the company.
It’s common for FMV and SMV to differ, as they serve different purposes and are often based on different methodologies and assumptions.
The FMV is set by a 409A valuation, conducted for tax compliance purposes to determine the fair market value of the company’s common stock. This is done solely for the purpose of issuing equity-based compensation. The valuation is required by the IRS, and is based on specific guidelines and regulations that the appraiser must adhere to.
On the other hand, the SMV is set by investors valuing the potential value of the company. The methodology may include a number of factors that are not used by an appraiser, such as a team, total addressable market, a deeper understanding of technology and comparable companies, as well as competition from other investors interested in the company. Investors may also take into account factors specific to the investor’s investment criteria, such as the expected return on investment, the level of risk and the investment horizon.
As a result, the two valuations may differ in their outcomes. It’s very common for the SMV to exceed the FMV.
FMV and Employee Taxes
When you are issued and sell startup stock, it’s important to understand the tax implications. In each of the examples below, the price per share is set by the FMV. Here are some things to keep in mind:
- Section 83(b) Election. If you receive restricted stock as compensation, you may consider making a Section 83(b) election [Link to: 83(b)]. This allows you to pay taxes on the FMV of the stock at the time of grant, rather than at the time of vesting. Making a Section 83(b) election can be helpful if you expect the stock to significantly increase in value before it vests. However, it’s important to talk to a tax professional before making this decision, as there may be risks.
- Capital Gains Tax. If you sell your shares for a profit, you will likely have to pay capital gains tax. This tax is based on the difference between the sale price and the purchase price. The tax rate for long-term capital gains (assets held for more than one year) is usually lower than the rate for short-term capital gains (assets held for one year or less).
- Alternative Minimum Tax. You may also have to pay alternative minimum tax (AMT) when you exercise your stock options. AMT is a separate tax system with its own rules and rates. It’s designed to ensure that high-income individuals pay their fair share of taxes.
- Qualified Small Business Stock Exclusion. Under certain circumstances, you may be able to exclude up to 100% of your gain from the sale of qualified small business stock (QSBS) from federal income tax. To qualify for this exclusion, these conditions must be true:
- The stock must have been issued by a domestic C corporation with gross assets of $50 million or less when the stock was issued.
- You must have held the stock for at least five years.
- You must have acquired the stock in exchange for money or property (not including publicly traded securities).
- The company must have used at least 80% of its assets in an active trade or business during substantially all of the time it held your stock.
Calculating the SMV is relatively straightforward: (Current Company Valuation x Percentage Ownership) / Number of Shares.
- Current Company Valuation: The current company valuation is the post-money valuation from the latest round of funding.
- Ownership Percentage: Your ownership percentage at any given time is equal to the number of shares you own / total number of outstanding shares. Note that this will give you an accurate percentage in the moment, but remember that the number of shares outstanding may increase during a round of funding, as stock options are exercised, warrants are exercised or Simple Agreement for Future Equity (SAFEs) are converted. So, you may want to also calculate the percentage on a fully diluted basis. To learn more about the difference between outstanding shares and fully diluted shares, click here.
- Number of Shares: The number of shares is the total number of shares held by the shareholder at that time.
So, let’s say that our startup, Gregarious Games Inc., just closed its Series A at a post-money valuation of $65 million. After the founder, James, has been diluted by the Series A, he has 2 million shares of 11 million outstanding shares.
James’ ownership percentage is 18% (2,000,000 / 11,000,000 = 0.1818). The current company valuation is $65 million. So, the total value of James’s stock is $11.7 million. And the SMV price per share is $5.85 ($11,700,000 / 2,000,000 = $5.85). Note that since James is a founder, he purchased his shares at the FMV of $0.00001 / share, or $20, and the SMV is now $5.85 / share or $11,700,000.
SMV Is Theoretical, Until It’s Not
One significant caveat about SMV is that it is purely a theoretical number. Unless a buyer is willing to purchase James’ shares at $5.85 per share, it is just a number on paper. James may find that potential buyers are not willing to pay $5.85 per share during discussions. They may believe that the investors overvalued the company in the last round of funding, and therefore only want to pay $4.50 per share. Remember that SMV is purely theoretical until the deal is signed, and the money has been deposited into your account. Only then is it real.
How Funding Rounds Affect the Value of Startup Stock
Funding rounds can have a significant impact on the value of startup stock. As a company grows and expands, it often requires additional funding to continue expanding. However, each funding round will lower the existing shareholders’ percentage ownership in a process known as dilution. To learn more about the impacts of dilution, click here.
But does this mean that the SMV has decreased? Not necessarily. Ideally, the startup’s valuation has increased with each funding round. This means that a shareholder’s stake may be worth more even though her percentage ownership is lower.
It is crucial for founders and employees to understand how funding rounds can affect the value of startup stock. By staying informed and working with knowledgeable professionals, investors can make informed decisions about their investments and risk tolerance. If you have questions about startup equity and are looking for legal counsel, feel free to reach out to us here.