While we'll be spending plenty of time talking about 409A in the abstract, Jason and I thought we'd give you a real life example of the analysis for one of our portfolio companies. Following is the essence of an email I received from one of my colleagues last week about a company of his that went through a formal valuation process for 409A.
For those of you who have portfolio companies going through an external valuation analysis as a solution to 409A, we are just completing the process with Company X and wanted to let you know about some of the issues that you may want to be aware of. While the analysis still has not been finalized, the price per share that was determined by the external consultant went from $0.43 after the first iteration, down to $0.10 in the most recent turn. Clearly this process is as much art as science and can have a meaningful impact to both the company as a whole and the individual shareholders. With respect to the analysis:
- The valuation consultant used the AICPA guidelines from the practice aid called "Valuation of Privately-Held-Company Equity Securities Issued as Compensation" as the template for their analysis.
- The analysis uses a basic DCF model to determine the enterprise value, and then Black-Scholes to derive the option value of common shares.
As a result, even if the enterprise value is determined to be less than the liquidation preferences, common shares can be assigned significant value due to this valuation methodology. While the most obvious issue is getting the DCF model correct (e.g. discount rate, exit value, etc) some other big levers that changed the valuation for $0.43 to $0.10 were:
- The valuation company did not take into account properly the liquidation structure; in particular, they did not realize Company X Series A shares were participating preferred.
- A very high volatility coefficient was used as part of the Black Scholes model, thus dramatically increasing the option value of the common shares.
- The valuation company did not properly model the debt.
The difference between the initial valuation for common shares of $0.43 and the final valuation of $0.10 is obviously very significant. While I’m sure the valuation consultant “appreciated” the help, in a perfect world it shouldn’t be necessary. However, we clearly aren’t living in a perfect world, especially when it comes to 409A.
COMMENTS (1)
Excellent Posting...very insightful - thank you!
As an appraiser, I must say that I would genuinely be thrilled to work with a "genuine" VC person on a 409a appraisal. What fantastic insights and educational possibilities!
I'm certain that the appraiser was grateful to be working with someone as qualified as your colleague appears to be ---- did the appraiser graciously accept the input? Was the input graciously rendered?
There does appear to be a bit of "gotcha" in your colleague’s tone: was the appraiser made aware of the participation element of the Series A prior to the "draft" conclusion. Did your colleague agree with appraiser’s methodology in the beginning of the engagement? Did you colleague readily suggest alternative methods?
Also, my read of the AICPA publication would suggest that the common stock in such a scenario (enterprise worth less than liquidation preference) should have no value (in a liquidation scenario), and common knowledge suggests that Black-Scholes is very sensitive to the volatility assumption --- perhaps I'm not interpreting Appendix I of this publication correctly, perhaps that appraiser didn't!
A healthy - and respectful - amount of discussion should always take place between appraiser and client prior to finalizing the conclusion. Your readers should know that the post seems quite one-sided, fairly snooty and perhaps a bit unfair.
Graciously Submitted,
MSK
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