Some 409A valuations are straight forward and uncomplicated. However, a surprising number involve unanticipated complexities due to a number of factors, including the following.
- The capital structures of most venture-funded companies are most often comprised of common stock and several series of preferred stock. The rights and priorities differ among the various classes and series of stock, with the common stock usually occupying the low rung on the ladder;
- Very early stage companies have very limited operational history and financial results to provide a foundation for valuation analysis;
- The prices paid by investors in equity financing transactions may be complicated by considerations beyond investment such as establishing a strategic relationship or providing liquidity to company founders; and
- The company’s audit firm may request valuation calculations as of several historical dates.
We, of course, would prefer that every 409A/123(R) valuation was as simple and straight forward as is commonly believed. However, the following brief examples are illustrative of the types of complexities that can arise in connection with any “routine” 409A/123(R) valuation. We enjoy meeting the valuation challenges presented by these types of situations, but there aren’t any text book answers – our experience is our greatest asset when valuation reality lies below the surface.
Valuing common stock of very early stage companies.
Many of our client’s have engaged us initially to value their common stock before the company has made much progress toward its objectives. The only meaningful information they are able to provide consists of an annual expense budget and the terms and amount of their initial equity financing round. Under those circumstances, it is necessary to estimate the value of common stock by using the price paid by investors for preferred stock as a starting point (often referred to as “backsolving”). However, when the backsolving approach is applied to companies immediately following their first investment round, a comparatively high estimate of value for the common stock often results. When we have encountered those situations, we have worked with company management to identify other measures of early stage value to augment or cross check the backsolving estimate.
First Independent Audit of Financial Statements.
The company’s first external audit presents many challenges. Among other things, the audit process is likely to examine the company’s records going back to inception. As it relates to stock options, GAAP requirements related to the accounting for compensation expense resulting from stock options may cause the audit firm to examine all 409A valuations and to seek other evidence (including retrospective valuations or calculations) of the fair value of the common stock at various points in time in the past. Often the historical information available to support a retrospective valuation is very limited. We have supplemented our 409A/123(R) valuations for a number of clients with additional valuation calculations as of different historical dates to satisfy the audit requirements of their Big 4 or other audit firms.
By way of example, for several clients, we have been able to apply the knowledge gained from our 409A work for each client to provide common stock valuation estimates as of two or three additional historical dates to facilitate the audit firm’s audit of the company’s stock option compensation expense.
Unraveling Complex Transactions.
After several years of valuing private company common stock, we have become adept at unraveling complex equity structures, stock transactions, and business relationships and giving them proper consideration in the valuation process. Examples include:
- Bundled Transactions. It is common valuation practice to use the price paid by investors for preferred stock in a recent equity financing round as the starting point for calculating the value of the common stock at the same point in time (“backsolving”). However, in some instances, the investors in the latest financing round purchase a bundle of stocks comprised of two or more series or classes. Because the entire bundle is being purchased for a fixed total investment, there is considerable latitude regarding the nominal price per share established for each item in the bundle. This can result in nominal values for each of the components of the bundle that differ significantly from their actual stand alone fair market values, which in turn complicates the backsolving calculations.
For example, one client had recently completed an equity financing round in which the investors had purchased a combination of the latest series of preferred stock, an earlier series of preferred stock and common stock. In the financing documents, prices per share were established for each element of the bundle but the price for the common stock (and the price actually paid to the founder to purchase a portion of his founders stock) was almost equal to the stated price for the latest series of preferred stock. Applying some sophisticated valuation methods, we were able to determine the actual fair market values of each item in the bundle which were considerably different from the nominal values in the financing documents (much higher for the latest preferred stock and much lower for the common stock).
- Strategic Investments. Some investments are made for a combination of purposes, some of which are beyond simply earning an investment return. The “investor” may have other business motives for making the investment such as fostering a strategic business relationship, gaining access to information and influence or obtaining a preferential position as a supplier or customer. When a “strategic” investment is made, the price paid for the client’s equity securities may be distorted by or intertwined with the investor’s other business objectives. Consequently, the information that the investment provides about the implied value of the company and the common stock may be misleading.
One of our clients entered into an important business alliance with a strategic partner. The partner made a modest (a few million dollars) investment in our client’s common stock but was primarily motivated by the opportunity to capture exclusive access to the client’s creative talent for a period of several years. On the surface, the price paid for the client’s common stock was very generous. However, in reality, the investor was paying a premium for the stock to achieve its other business objectives. We examined the overall transaction in great detail and determined that the fair market value of the common stock actually was considerably lower than the nominal value paid by the investor.