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Forbes
5 days ago
- Business
- Forbes
Evaluating How Equity Transactions Impact A Company's Valuation
Meenal Aggarwal is the founder of Groots Valuation with expertise in valuing stocks, intangible assets and complex financial instruments. When a company engages in equity transactions, whether issuing employee stock options, facilitating a secondary trade or repurchasing shares, the implications on its valuation can be substantial. Understanding the nuances of these transactions is essential for both financial reporting and tax compliance. As the founder of a financial advisory firm that specializes in valuations, I've created a practical set of questions designed to help valuation professionals assess the relevance and reliability of recent transactions in a company's securities. Evolving Standards On June 23, 2024, the Association of International Certified Professional Accountants' (AICPA) Financial Reporting Executive Committee issued a working draft of chapters eight and nine as part of a forthcoming update to the 2013 AICPA Accounting and Valuation Guide. Here, we'll focus on chapter eight, "Inferring Value from Transactions in a Private Company's Securities." This chapter discusses the framework to calibrate equity securities valuation with a company's primary transactions, secondary transactions and repurchases. Companies typically assess the value of underlying equity when issuing instruments like employee stock options (ESOPs) or other share-based compensation. This valuation may serve two purposes: determining fair value for financial reporting—guided by U.S. generally accepted accounting principles (GAAP), specifically Topic 718 of the FASB Accounting Standards Codification—and establishing fair market value for tax purposes under Section 409A of the Internal Revenue Code. Chapter eight suggests that the secondary market transactions are relevant for the valuation if: • The transaction involves an identical security on the measurement date. • It occurs in an active market. • The evidence indicates the transaction is orderly. An identical security ensures you're comparing apples to apples. An active market suggests genuine supply and demand, and an orderly transaction implies it wasn't a distressed sale, thus providing a more reliable price point. These criteria are important because they help ensure that the transaction price accurately reflects the company's true value. The working draft from June 2024 expanded on the qualitative and quantitative factors influencing the relevance of primary and secondary transactions. This expansion means valuation professionals now have more detailed guidance and a broader set of considerations to evaluate how relevant a past transaction is to a current valuation. It's significant because it helps companies and professionals achieve more accurate and defensible valuations, particularly as private company transactions become more complex and frequent. This increased clarity can lead to better financial reporting and reliable valuation. A Framework For Evaluating Transactions: 30 Questions To Ask Based on my interpretation of Chapter 8, the following 30 questions can offer a practical way to organize those considerations. This is not an exhaustive list. They may be useful for both the valuer and the company when evaluating secondary transactions and could also serve as part of a data request from a valuer to a client. 1. Is the transaction in an identical security? 2. Is the transaction recent? 3. Have any changes occurred in the business between the transaction date and the valuation date? 4. Is the transaction on a control or minority basis? 5. What percentage of shares is acquired? 6. Do the acquired shares change the status of the shareholder from minority to control? 7. Are the volumes considerable enough? 8. Was the company in distress before the transaction? 9. Was the transaction forced? 10. Is the investor strategic or financial? 11. Is the transaction between related parties? 12. Were there multiple buyers or a single buyer? 13. Was there any pre-existing relationship between the buyer and seller? 14. Was the price negotiated? 15. Was the due diligence done before acquiring shares? 16. Were there customary marketing activities before the sale of shares? 17. Was there enough time to market? 18. Was the transaction one-time or repeated? 19. Were all shareholders given a chance to participate in the transaction? 20. What was the motivation of the buyer? 21. What was the motivation of the seller apart from raising funds? 22. Are there any other features involved with the sale, such as tag-along rights? 23. Are there voting rights? 24. Were there any other transactions along with this transaction? 25. Did the transaction occur in the principal or most advantageous market? 26. Was the transaction price an outlier? 27. Were the parties willing to do the transaction? 28. Were the parties able to do the transaction? 29. Were the parties knowledgeable of relevant facts? 30. Was the price an 'exit" price or an 'entry' price? These questions are valuable because they provide a comprehensive framework for scrutinizing past transactions. They can be asked whenever a valuation professional is considering using a recent transaction as input for their valuation judgment. They can help ensure the transaction is orderly, at arm's length and representative of true market value, ultimately leading to a more accurate and defensible valuation. For instance, a forced sale (question nine) or a transaction between related parties (question 11) might not reflect an arm's length market price. Similarly, knowing if the buyer was strategic or financial (question 10) can reveal different motivations that influence price. Moving Forward: Best Practice For Professionals As valuation standards continue to evolve, staying current with guidance from organizations like the AICPA is paramount. Valuation professionals and companies alike should proactively integrate these comprehensive questions into their assessment processes. By meticulously evaluating the nuances of equity transactions, professionals can not only enhance the reliability of their valuation judgments but also ensure greater compliance with financial reporting and tax regulations. Embracing this disciplined approach will be key to navigating the increasingly complex landscape of private company valuations and fostering confidence in reported financial figures. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation. Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?
Forbes
06-05-2025
- Business
- Forbes
How Funding Decisions Influence Founder Ownership
Meenal Aggarwal is the founder of Groots Valuation with expertise in valuing stocks, intangible assets and complex financial instruments. getty Early-stage privately held companies often need funding to grow. Growth requires money, and startups use various financial tools to raise funds. While raising more money can fuel growth, it may also reduce the founder's equity ownership and gradually shift control to investors. Similarly, raising funds at a higher valuation can minimize dilution but may create pressure to meet heightened expectations. Given this, it's important for founders to carefully select financial tools to avoid surprises like equity dilution and ensure the chosen option aligns with their goals and the company's objectives. My company conducts private company valuations, which has given me deep insights into the intricacies of these processes. We have worked closely with numerous founders, assisting them in valuing their equity, convertible debt, warrants and other financial derivatives. Time and again, I have observed that founders are often surprised when we account for the full impact of these tools on their stock price. Understanding different financial tools can help founders in their funding decisions. Common Financing Tools Simple And Convertible Debt Founders can raise funds either through debt or equity. Generally, simple debt does not dilute founder equity. In this context, "simple debt" refers to a straightforward loan that is repaid in cash, along with any agreed-upon interest, by a specified maturity date. Unlike convertible debt, this type of debt cannot be converted into equity, remains solely a financial obligation, and therefore does not lead to dilution. Convertible debt is a loan that can either be repaid or converted into equity. Conversion often happens during major events, like equity financing, a change of control or at the choice of the holder. If no event occurs, the company repays the loan. Common And Preferred Stock Common equity tools generally include issuing common stock or preferred stock. Common stock represents ownership in a company and typically comes with voting rights, allowing shareholders to influence corporate decisions. Companies can issue common stock shares directly to investors. This process often involves creating new shares for investors, which can dilute the ownership percentage of existing shareholders. Preferred stock, on the other hand, generally doesn't carry voting rights but offers priority in dividend payments and claims on assets in the event of liquidation. Like common stock, issuing preferred stock can also lead to dilution. In my experience, venture capital or private equity firms typically invest in these shares depending on the company's stage. Founders commonly use terms like "pre-money valuation" and "post-money valuation," which typically assume equal value for preferred and common shares. However, their values can vary. For example, before an initial public offering, when preferred shares are expected to convert into common shares, their values might equalize. Conversely, during a wind-down, the preferred stock might hold greater value due to its priority in receiving proceeds. Secondaries And SAFEs Secondary transactions are another common tool. This refers to when founders or existing shareholders sell their shares to investors rather than creating new ones. Alternatively, a simple agreement for future equity, known as a "SAFE," is a promise to issue shares upon a future event, such as the next equity financing round. Shares are typically issued at a price that reflects either a discount to the new round's price or a pre-determined valuation cap. How Different Tools Impact Dilution The financial tools you choose significantly impact the dilution of your equity, the valuation of your shares and the decision making power of investors. We can illustrate how the tools described above may impact dilution with an example. Let's say a company called ABC has a single founder holding 1 million shares, each valued at $1. Before raising funds, the founder owns 100% of the company's equity. ABC plans to raise $100,000 from investors. Here's how the founder's equity could change based on the chosen tool and its terms from the current 100%: • Common Stock (Primary Transaction): Issuing common stock at $1 per share results in 100,000 new shares for raising $100,000. The founder's equity decreases from 100% to about 91% (1 million founder shares divided by 1.1 million total shares). • Common Stock (Secondary Transaction): If the founder sells 100,000 existing shares to investors, the founder retains 90% equity (900,000 founder shares divided by 1 million total shares). Total shares do not change in secondary transactions, as the founder sells their own shares. • Preferred Stock: Let's say the preferred stock is issued at $2 per share, and 50,000 shares will be issued to raise the targeted $100,000. Assuming one preferred stock converts to one common stock, the founder retains 95% equity (1 million founder shares divided by 1.05 million total shares). • SAFE: Founder dilution occurs at a future event (e.g., equity financing). The extent of dilution depends on the SAFE's terms, such as valuation caps and discounts. The type of SAFE (pre-money or post-money) also plays a role in determining dilution. • Convertible Debt: Similarly, founder dilution happens when debt converts into equity. The extent depends on the terms of the note, such as the conversion price. Lessons For Founders To determine which option is best for you and your business, ask yourself a few key questions: What funding options are available to you? How much funding do you need to raise immediately to achieve the company's objectives and ensure the business remains operational? How much control are you willing to relinquish? What percentage of equity dilution are you prepared to accept? Would it be more advantageous to dilute equity now or at a later stage? Once you've thoughtfully navigated these questions, you can select the tool that best suits your needs. Selecting the right financial tool is a critical decision for founders of early-stage companies. Each option carries unique implications for equity dilution, valuation and future growth. By thoroughly evaluating these tools and aligning them with both personal and organizational goals, founders can raise the funds they need while preserving their equity. Thoughtful planning today ensures a stronger foundation for tomorrow's success. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation. Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?
