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Valuation is the number founders talk about most and understand least. A Palo Alto startup can have a headline valuation in its term sheet, several caps on its SAFEs and a much lower 409A value on its common stock, all at the same time. Each one answers a different question. This page sorts them out.
This page is general information, not legal, tax or financial advice. The figures are hypothetical. Tax rules on 409A are complex, so work with an accountant, an appraiser and a lawyer on your own company's numbers.
Pre-money and post-money
The pre-money valuation is what the company is worth immediately before new money comes in. The post-money valuation is the pre-money plus the new investment. The new investor's ownership is the investment divided by the post-money. Everyone who owned shares before is diluted by the same fraction.
Investors set a price per share by dividing the pre-money valuation by the pre-money fully diluted share count. Fully diluted usually includes the option pool and any SAFEs or notes converting in the round. That is why the size of the option pool matters so much: a bigger pre-money pool lowers the price per share for everyone already on the cap table.
Worked example: pricing a round
The numbers below are hypothetical. A company has 8,000,000 fully diluted shares and agrees to raise $4 million at a $16 million pre-money valuation.
| Step (hypothetical) | Calculation | Result |
|---|---|---|
| Price per share | $16,000,000 / 8,000,000 shares | $2.00 |
| New shares issued | $4,000,000 / $2.00 | 2,000,000 |
| Post-money shares | 8,000,000 + 2,000,000 | 10,000,000 |
| Post-money valuation | 10,000,000 x $2.00 | $20,000,000 |
| New investor ownership | 2,000,000 / 10,000,000 | 20% |
The same $4 million buys very different stakes at different pre-money valuations:
| Pre-money (hypothetical) | Post-money | Investor ownership | Existing holders keep |
|---|---|---|---|
| $12,000,000 | $16,000,000 | 25.0% | 75.0% |
| $16,000,000 | $20,000,000 | 20.0% | 80.0% |
| $24,000,000 | $28,000,000 | 14.3% | 85.7% |
How investors arrive at a number
Early stage valuation is a negotiation more than a formula. Investors usually start from how much the company needs to raise and what ownership they want, then work backward to a valuation. Other inputs include progress such as revenue or technical milestones, competition among investors, the team's track record and how similar companies were recently priced. A company with several term sheets has more room to negotiate than one with a single offer.
Founders should be careful about raising at the highest number they can get. A very high valuation sets a bar the next round must clear. If the company misses it, the next round may be a down round. Our down rounds guide explains what happens then.
SAFE caps are not valuations
A post-money SAFE cap tells you the most the SAFE investor will pay and therefore the most ownership it can receive. A $1 million SAFE at a $10 million post-money cap buys about 10 percent before the priced round. Y Combinator's user guide warns that caps "are just that -- caps, rather than final valuations." If the priced round comes in below the cap, the SAFE converts at the round's lower price. Our SAFE guide works through a conversion. YC posts the full guide on its documents page.
Headline versus effective valuation
The number announced in a press release is not always the number founders effectively received. Three terms can shrink it:
- A pre-money option pool increase. New pool shares count before the round, so they dilute only existing holders. Our cap tables guide shows this in numbers.
- Larger or participating preferences. A high valuation with a 2x preference can pay founders less in a modest sale than a lower valuation with a 1x preference.
- Converting SAFEs and notes. They convert at their own lower prices, which takes ownership from existing holders before the new money arrives.
When you compare term sheets, compare founder ownership after the round and the payout in a few sale scenarios. Those two figures capture what the headline leaves out.
409A valuations
Section 409A of the Internal Revenue Code covers deferred compensation. Stock options granted below the fair market value of the stock on the grant date can fall under it. In general terms, the employee may owe income tax as the options vest plus an additional 20 percent federal tax and interest. California has its own additional tax. To avoid that, private companies set option exercise prices at or above a supportable fair market value, usually from an outside appraisal called a 409A valuation.
The Treasury regulations describe methods that are presumed reasonable. The one most venture-backed startups use is an appraisal by a qualified independent appraiser, dated no more than 12 months before the grant. Another applies to illiquid stock of young startups: a written valuation by a person with significant relevant knowledge and experience, available only when the company meets conditions on age and has no expected sale or IPO in the near term. The IRS can still challenge a value that is grossly unreasonable.
A hypothetical 409A
Continuing the example, investors paid $2.00 per share for preferred stock. A 409A appraiser might value the common stock at about $0.60, reflecting the preferred stock's liquidation preference, its other rights and the lack of a market for common shares. The board would then grant options with a $0.60 exercise price. That gap is normal. Our liquidation preferences guide shows why preferred is worth more.
When to refresh it
- At least every 12 months.
- After a priced round or any SAFE or note that signals a new value.
- After a major event such as a large contract, a failed product or an acquisition offer.
- Before a large batch of option grants if the last report is getting old.
What Palo Alto founders typically ask
Who does 409A valuations?
Specialist valuation firms, some accounting firms and some cap table software providers offer them. Our accounting firms guide lists firms that work with Peninsula startups. Ask your lawyer whether a provider meets the independence standard.
Can we grant options right after a SAFE without a new 409A?
Be careful. Lawyers often treat a new SAFE at a higher cap as information an appraiser should consider. Ask counsel before granting options after any financing.
Does the 409A affect what employees can sell their shares for?
Not directly. Secondary buyers and tender offers set their own prices, which can differ from the 409A. Our secondaries guide covers this.
Should we chase the highest valuation?
Not at any cost. Compare the full package of terms, the investor and the bar the valuation sets for your next round. A slightly lower number with clean terms and a strong partner is often the better deal.
Good to know
- Keep every 409A report. Auditors, acquirers and investors will ask for the history.
- For the vocabulary used here, see our venture capital glossary.
Frequently asked questions
How do you calculate post-money valuation?
Add the new investment to the pre-money valuation. A company valued at $16 million pre-money that raises $4 million has a post-money valuation of $20 million. The new investor's ownership is the investment divided by the post-money valuation, here 20 percent.
Is a SAFE valuation cap the same as a valuation?
No. A cap sets the most an investor will pay per share when the SAFE converts. The company's actual valuation is set later in a priced round. Y Combinator's SAFE user guide says caps are just that, caps, rather than final valuations.
What is a 409A valuation?
It is an appraisal of the fair market value of a private company's common stock, named after Section 409A of the Internal Revenue Code. Companies use it to set option exercise prices. Options priced below fair market value can bring extra taxes for the employees who hold them.
Why is the 409A price lower than the price investors paid?
Investors buy preferred stock, which carries liquidation preferences and other rights. Common stock has none of those, so it is worth less. A 409A appraiser accounts for those differences and for the lack of a public market.
How often does a startup need a 409A valuation?
Most venture-backed startups get one at least every 12 months and after any event that could change the value, such as a new funding round. An independent appraisal more than 12 months old no longer supports the safe harbor presumption.