Now that you hold equity in a company, how do you determine what it’s worth? The value of equity is a moving target in any company, dependent on factors such as the stage and growth of the company, dilution and possible exit events. At the most basic level, you’ve been given the opportunity to buy stock at the lowest possible price today with the hope for significant upside tomorrow. Without a crystal ball, it is impossible to know exactly what, if any, that upside will be. However, several indicators can provide you with a good estimate of a company’s value.
Stock or Option Price v. Value
First, it’s important to know that the strike price of your stock is not the same as the value. The value of your stock is based on the value of the company, while the strike price is a reflection of the fair market value of the stock on the date you received the grant. If a company is worth $500 million and your ownership interest is 0.5%, then your stock is worth a total of $2,500,000. On the other hand, if your exercise price was $0.25/per share and you purchased 10,000 shares, you paid a total of $2,500 for stock that is now theoretically worth 1000x as much. However, remember that just because your stock is valued at a certain price does not necessarily mean that you will be able to immediately realize that value.
So how do you determine the value of your stock?
One factor in determining the value of your stock is the stage of the company. Public companies are the easiest since the market value of its stock is published every day. To determine the value of your stock, simply multiply the number of shares you own by the current market value. For example, if the current market value is $5/share and you own 10,000 shares, your stock is worth $50,000. This means you can sell your stock on the open market for up to $50,000. Similarly, if the company is preparing for its Initial Public Offering (IPO) you’ll soon know how much one share of stock is worth. However, remember that your stock is most likely subject to a lock-up, preventing you from selling on the open market for a period of time after the IPO (usually 6 months to 3 years).
A private company that has undergone one or more equity financings will have been valued by the investors at the time of the financing. The price per share that investors pay for preferred stock is based on either a pre-money or post-money valuation of the company. For example, if a company raises $5 million on a $15 million pre-money valuation, then the company will be valued at $20 million post-financing. The value of your stock is equal to your percent ownership times the post-financing valuation. Be sure you use your post-financing ownership percentage since your ownership will decrease after the financing (see below for discussion on dilution). For example, let’s say you owned 0.5% of the company prior to the financing and after the financing your ownership was diluted to 0.4%. If the company is valued at $20 million post-financing, your stock is worth 0.4% of $20 million, or $80,942.51. Remember, though, that because you hold stock in a private company, you most likely will not be able to immediately sell your stock for this amount since there is no public market and finding a third party to purchase your shares could be difficult. Additionally, since you hold common stock, a third party may not be willing to pay full value for your shares since they cannot be sold on the open market and are currently worth less than the preferred stock.
If the company is pre-financing and has not been valued by an independent party such as a potential acquirer or a potential preferred stock investor, then you have little data to work with in order to determine the value of your stock. Your best option is to look at peer group companies that have gone public or that have published data on recent financings. This will give you an idea of the potential upside of your stock, though only an estimate.
As mentioned above, every time a company undergoes an equity financing your ownership interest will be diluted. As a reminder, your ownership percentage is determined by dividing the number of shares you hold by the total number of shares currently outstanding (including any promised but unissued shares). In the process of an equity financing a company issues new shares to the investor group and also usually increases the number of shares reserved under its stock plan. This results in a larger number of outstanding shares, effectively reducing your ownership interest. For example, if you own 65,000 shares and the company has 13,000,000 shares outstanding pre-financing, your ownership interest is 0.5%. If the company then completes a preferred stock financing, after which there are a total of 17,000,000 shares outstanding, your ownership interest will have decreased to 0.38%. Dilution affects the value of your stock in the absolute sense, since your slice of the pie will be reduced over the course of several financings. However, keep in mind that financings increase the value of the company overall since they represent forward movement, increased capital and investor confidence in the company. While dilution is unfortunate, it’s inevitable with a successful company. You can try to protect yourself from dilution by negotiating “top-up” grants or, if you’re a very senior employee, an anti-dilution provision in your original grant.
Selling Common Stock at the Current Fair Market Value
If you are looking to sell your common stock immediately, your best bet will be to wait until the company completes a valuation of its common stock. A valuation, sometimes called a 409A valuation, is obtained by a company after completing a financing, achieving a major milestone or within one year after the last valuation. An independent valuation company will review information such as the company’s financial forecast, peer group companies for comparison purposes, financing or acquisition offers, secondary sales and other information affecting stock value. With a current per share fair market value of the company’s common stock, you can comfortably negotiate a price for your stock with a willing third party. Remember, though, that the company almost always has a “right of first refusal” on your stock, meaning you will have to give them the right to buy the stock before selling to a third party.
Company Exits and Preference Stacks
If the company decides to merge or be acquired you may be wondering what you will receive. Again, this is a product of the value placed on the company by the buyer in the form of the purchase price. The purchase price may be cash, stock in the acquiring company or a mixture of the two. However, several factors will likely reduce the amount you actually receive in this type of exit.
Let’s say an acquirer offers to purchase the company for $2 million. First, the company must pay off all of its current debt. For example, if the company has $500,000 in debt, $1,500,000 will be left in proceeds. Next, a portion of that money will likely be “placed in escrow,” which means it will be held back by the acquirer for an amount of time ranging from 3 months to 3 (or more) years. This money is a sort of insurance policy for the buyer that it’s getting what it bargained for. Assuming there have been no issues requiring payments from the escrow fund, after the agreed to time period has expired that money will then be distributed among the company shareholders. Let’s say here that the escrow amount is another $500,000. Now you are left with $1 million in immediate proceeds.
Next, the company will determine how to distribute the immediately available proceeds. If the company has undergone a preferred stock financing, then the preferred stock holders are first in line to be paid. Referred to as the preference stack, the company must first repay the preferred stockholders the amount of their original investment (or sometimes a multiple, depending on the deal). If the transaction is a “fire sale,” meaning the company was failing and the buyer is really only interested in the underlying intellectual property, then the amount left to be distributed after repaying all debt and funding the escrow may only be enough to pay the preferred stockholders. This means the common stock holders could get nothing. For example, if the company raised a total of $5 million over the course of its existence, then in this case the remaining proceeds after escrow ($1 million) are insufficient to even repay the preferred stock holders and the common stock holders will not receive anything. If, on the other hand, the company raised only $200,000, then it will be able to repay the preferred stockholders first and will still have $800,000 left to distribute to the common stockholders. However, the preferred stockholders also have the right to convert their shares from preferred stock to common stock if doing so will result in a larger payout. In this scenario, even after converting the preferred stock, common stockholders can still expect to receive money from the transaction.
Questions to Ask Your Employer to Help Determine the Value of your Equity
Has the Company raised any money? If yes, how much, when and in what round?
What was the company valued at in the last round?
When does the company plan to raise more money?
When did the company last receive a 409A valuation and what was the common stock valued at? When will you complete the next valuation?
What is the hiring plan?
How much equity is set aside for employee option grants?
Is this amount included when determining the percentage of equity being offered to me?
What are the short-term and long-term plans for the company, including growth rate, revenue, number of employees and market position?
DISCLAIMER: The foregoing summary is not intended to be tax advice. The tax consequences of stock and options will vary depending on the specific circumstances of each taxpayer. Therefore, each taxpayer should seek advice from an independent tax adviser. The author expressly disclaims any and all liability associated with any decisions or actions taken in reliance on the contents of this or any associated articles.