From the category archives: Valuation
My article “Valuing Common Stock in Anticipation of a Biotech IPO” appeared in the May 2012 issue of Business Valuation Update, published by Business Valuation Resources. Here are a few takeaways:
• The window for biotech IPOs is open.
• A company’s venture investors are virtually required to invest in the IPO as well. It’s not a liquidity event for the VCs. It’s another financing.
• The SEC requires the company to explain the difference between the estimated offering price and the strike price on its options.
Stock options are an important form of compensation in venture-backed companies. Accounting guidance (ASC 718) requires the issuing company to record the expense associated with each option. The value of the option depends on its strike price relative to the value of the underlying security (common stock). Prior to a public offering, the value of common stock in a private company is an unknown. Nevertheless, with the help of appraisers, companies are ...
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Is there a rule of thumb for valuing common stock relative to preferred? If a new preferred round is priced at $1.00 per share, can we assume that the value of common is $0.10? No.
By now, most managers of venture-backed companies understand that the old 10% rule is dead. The AICPA Practice Aid (Valuation of Privately-Held-Company Equity Securities Issued as Compensation) states “The use of ‘rules of thumb’ is not (and never has been) an appropriate method for estimating the fair value of a company’s common stock.” Nevertheless, many managers still want to get a sense of the common stock’s value before engaging a valuation specialist. Once the draft appraisal is completed, managers often respond by saying it doesn’t “feel” right.
The guidance is the guidance, but that doesn’t prevent us from at least asking the question: mathematically, is there a way we can reliably estimate the value of common r ...
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Venture capitalists have a short-hand nomenclature for valuation that causes confusion for appraisers and their clients. I’m referring to “pre-money” and “post-money” value. Assume a company has 10 million common shares outstanding and it issues 5 million Series A convertible preferred shares priced at $1.00 each. The pre-money value is equal to the product of the common shares outstanding times the Series A price (10,000,000 X $1.00 = $10,000,000). The post-money value is equal to the pre-money value plus the proceeds from the issuance of Series A ($10,000,000 + $5,000,000 = $15,000,000).
So what’s the problem? It’s that the value of the equity isn’t really $10 million. The VC pays $5 million for Series A shares with privileges the common stock doesn’t have. For example, the Series A preferred is entitled to a liquidation preference over the common stock. When we multiply the Series A price times all the ...
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One reason it’s difficult to value common stock in a venture-backed company is that the value of common is more volatile than the value of equity. A small swing in equity value, up or down, can trigger a much bigger change in the value of common. If we’re valuing equity based on market multiples, which change every day, the value of common is likely to bounce around.
The volatility is the result of financial leverage, the same phenomenon which contributes to higher earnings and losses in companies financed with debt. Unless equity value is high enough to trigger conversion of preferred, the preferred liquidation preference is like debt. Equity value may increase by a small amount, but if it all flows to common with none to preferred, the effect on common value can be dramatic. To illustrate, assume a venture-backed company is capitalized with 1,000,000 preferred shares and 500,000 common shares. The preferred liquidation preference is $10 per share, so the pr ...
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