October must have been a great month for seed investments in tech companies. I know this because I’m getting a lot of queries about how a zero* valuation can be compatible with fundraising.
I briefly addressed this in a post back in June. I mentioned that it’s very common for an early stage company to receive a zero valuation for tax purposes. Far from being something to anguish about – a zero valuation can be a good thing. It’s a great time to award shares to key employees and it shouldn’t affect your prospects of third party finance. In this post I’ll delve into that last point.
A quick recap on valuing private companies
Don’t shoot me because you disagree on the detail… here is a veeeery simplified explanation of how to value a private company:
Company value = sustainable earnings x an earnings multiple (plus or minus) debt, free cash and non trading assets
There are different earnings measures which require different things to added or deducted, but that’s enough detail for this post. This is intended to give you an idea of what a hypothetical buyer and a hypothetical seller might agree to sell the whole company. Divide by the number of shares to give the value per share (and discount that number because one share in a company is clearly worth less per share than a shareholding that entitles you to control the company).
There is only one correct approach to valuing shares in a company
Just kidding. If you want to start a brawl, stick that on a screen in front of a room of valuers, and then leave. Quickly.
Valuing shares is really about crystal ball gazing. It’s trying to predict what a human being would pay for the shares, if they were rational. Obviously this leaves huge room for reasonable and knowleadgeable people to disagree. To get some more clarity, we need to understand WHY we are valuing the company. For me, 100% of the time the answer is to work out the tax treatment of shares or options being given to employees. So what’s important here is what HMRC is in the habit of accepting.
What approaches to valuation will HMRC accept?
Broadly, HMRC will accept that a company can be valued at zero even if it has earnings. HMRC will do this even if the company received significant investment.
Let’s take the first point: valuing a company at zero even if it has earnings. First of all, just because a business has earnings does not mean they’re sustainable. There are a few typical reasons for a startup’s earnings not being sustainable. The founders may be working for free. The company may run out of working capital. The business may be taking advantage of a limited opportunity.
Now let’s take the second point: a significant investment does not mean there is a market for shares in that company. Angel investors are typically against founders using seed investors to purchase founder’s shares: seed investment almost always is used to subscribe for newly issued shares. Investors may be putting cash in for the tax advantages of the investment, or as a speculative investment. None of this means that shares in the company have a significant market value.
So you can honestly value a company at zero, even though it’s received external investment?
Yes. Don’t worry about it. HMRC expressly approve a huge number of valuations in these circumstances. Investors routinely see zero valuations for tax purposes.
- When I talk about a zero valuation, I’m doing that to avoid some jargon. The technically correct position is that it is a nominal valuation – in which shares are worth typically no more than a few pennies.