Four Considerations That Impact a Startup’s Valuation

While all startups want the highest valuation for their company, there are several adjustments to the initial valuation, with tax often being an afterthought. Some factors that can influence a startup’s valuation include: 

• Entity type
• Capital raising
• Equity awards
• Due diligence

Entity Type

The entity type can impact the startup’s valuation in two different ways. 

First, if the company is set up as a C-Corp, the stock is granted at a time when the tax asset value is less than $50 million, and it meets a few other criteria, the business stock could be considered a qualified small business stock (QSBS). This designation qualifies the holder of the stock for a gain exclusion at the time of the sale in the amount $10,000,000 or 10x basis, whichever is greater. Investors may be willing to pay more at the time of investment if they’re aware the future tax gain can be excluded from income. 

Second, the type of sale also has an impact, whether it be a sale of assets or a sale of equity. It’s important to understand the buyer and why they would want to have the transaction be treated as one rather than the other. 

Capital Raising

While raising capital will increase a company’s cash funds, it can also make their tax attributes limited due to I.R.C. Section 382. A 382 limitation is when ownership changes by greater than 50% of the value of the stock in a three-year period, based on the valuation of a company. Because of this rule and potential limitation, it is important for startups to keep a detailed cap table to ensure their tax attributes are as realizable as possible and not wait until they are in income to realize the net operating losses accrued are limited. 

Another way raising capital can impact a company is by increasing net worth taxes. This is important to consider as the company could be paying taxes even if still in a tax loss position.

Equity Awards

The type of equity awards a startup offers can affect the interest of potential investors. An I.R.C. Section 83(b) election can be made by an employee who is granted restricted stock. This election allows the holder of the stock to be taxed at ordinary rates at the date of the grant based on the fair market value on that date rather than at the vesting date. 

While this does have its advantages, there is a risk that the value of the stock will decrease when the vesting date comes. The benefit of this election is to save on taxes by paying less tax at ordinary income rates, and more at capital gains rates upon future sale of the stock. 

Due Diligence

Due diligence is another factor that will impact the company’s valuation. During a due diligence check, if tax issues are found, the diligence team must compute the potential exposure, which can be held in escrow or reduce the purchase price all together. 

It’s important to be due diligence ready before the company is ready to sell. It would be best if the company found everything swept under the rug and remediated any issues prior to a potential buyer uncovering the skeletons in the closet. 

Learn More on How Tax Can Impact Startup Valuation 

Overall, there are many factors that can impact the valuation of a startup and it’s important to be aware of all of them keep buyers’ interest and make the highest return on investment! 

To learn more about this topic, check out the webinar: Webinar | How Tax Can Impact Startup Valuations (eisneramper.com)