FAQ

Knowledgeable, qualified and experienced professionals that guide you adeptly through issues of value. That's Arcstone.



In theory, yes all this is true.  In practice it's harder to see the connection between future dividends and stock prices.  I usually use the terms "value" and "price" carefully in practice.  For example, I once valued Facebook at north of $50 per share; yet it traded far differently (far lower). The price was well below the value, in my opinion.  Back to your question:

  1. Q: In finance 101, they say that a stock price is equivalent to the discounted value of all future dividends. True? A: No. the value of the stock is equivalent to the discounted value of all future dividends; the price of the stock is a Keynesian beauty contest.
  2. Q:  If we could actually know all future dividend payouts in perpetuity for Company X, would the NPV of that cash flow equal the stock price? A: yes, the PV per share would equal the stock value.  For it to equal the stock price,we would all have to agree on a certain discount rate. 
  3. Q: Does buying one share of Google at $785 mean that expected value of discounted future dividends is going to equal $785?  A: Yes, as strange as it might seem. Perhaps it is easier to believe this if you chop infinity into smaller bits. Say you get 5 years of dividends that have a PV of $5, and then you sell to the next investor for the equivalent of (the PV of) $780.  That works, right?  Say the next investor does the same, and so on.

As a venture investor in the pre-409A era, I used to participate in board room discussions like the following:

"At what price should these stock options be issued?"
"Dunno.  What's the latest preferred?"
"$1.00"
"OK.  Let's set the options at 10 cents. Cool?"

That was the extent of our analysis.  

Now, as CEO of a nationally respected business valuation firm, we do things a bit differently.  There is no longer any true rule of thumb to describe the relationship between common and preferred pricing. However, as Josh McFarland suggests in his answer, the price, rights and preferences of preferred stock play a significant role in the valuation of common stock.  For good reason, of course.  This is especially true when the valuation analyst employs what is known as the "Option Pricing Method back-solve" to value the common.  

If pressed, I would say that common stock valuations for early stage (Series A through C) venture-backed companies range from 15% to 35% of the preferred.  Like I said, not much of a rule of thumb.

Finalized in April 2007, Internal Revenue Code section 409A applies to  discounted stock options and stock appreciation rights (SARs) defined as  deferred compensation. 

Under 409A, stock options that have an exercise  price less than the Fair Market Value of the underlying stock as of the  grant date could result in adverse tax consequences for the option  recipient.  The gain is subject to taxation at the time of option  vesting rather than the date of exercise, with potentially devastating  penalties and interest charges. In short, the consequences for  noncompliance, which affect the individual who holds the options and not  the issuing company, are significant.

Section 409A, while lengthy and complex, does outline some reasonably  clear approaches on how to develop compliant policies. These  presumptive methods, known as safe harbors, shift the burden of proof of  noncompliance to the IRS if implemented properly.  That simply means  that if a company employs a safe harbor method to value the price of its  stock options, the IRS must show that the company was grossly  unreasonable in calculating the fair market value of the underlying  security before wrongdoing may be claimed.    

There are a number of these safe harbor methods, including: (1) the  illiquid start-up, (2) binding formula, and (3) independent appraisal  approaches.  In order for any of the safe harbors to comply, however,  the method must incorporate evaluation of a number of factors,  including: (i) the value of tangible and intangible assets of the  company, (ii) the present value of future cash flows, (iii) the public  trading price or private sale price of comparable companies, (iv)  control premiums and discounts for lack of marketability, (v) whether  the method is used for other purposes, and (v) whether all available  information is taken into account in determining value.

First, valuation of stock options is required under IRC 409A (see 409A Valuations), so unless you are interested in flaunting US tax law, the answer to your question is simple: if you are issuing stock options, you have to conduct a valuation of those options under 409A.  

Second, perhaps the real question being asked here is "Why get an outside firm to conduct a 409A valuation?"  The answer to this question is many-fold, but the one nuanced aspect worth describing in detail is this: to easily fit into the safe harbor offered by 409A.  More on this below.

IRC 409A lays out rather severe penalties for optionees who have received stock options below Fair Market Value.  Managers of privately held companies are therefore highly motivated to ensure that they are issuing stock options in compliance with 409A (i.e., at or above Fair Market Value).  So what is the value of a stock option for privately company stock?  That's not an easy question to answer.

Enter business valuation (BV) professionals, who make their living by appraising illiquid and uncertain interests.  Many BV pros around the country have specialized in 409A valuations because it is a nuanced art that requires a deep understanding of venture-backed startups, tax valuation standards (Fair Market Value), financial reporting valuation standards (Fair Value), along with enforcement practices by the IRS and the SEC.  

Which essentially brings to the answer to the question: if a company hires a BV firm that is practiced in the art of startup company valuations, the resultant valuation is believed to fit into the safe harbor offered by the 409A; that is, the IRS will respect the valuation unless the company was “grossly unreasonable” in relying upon the valuation.  Thus, hiring a BV firm to conduct a 409A valuation offers several benefits:

  1. Ease.  BV pros (generally) know what they are doing
  2. Speed.  BV pros are (generally) efficient
  3. Quality.  BV pros (tend to be) competent and careful in their craft
  4. Cost.  The total cost of compliance is (often) significantly lower when using an outside firm than conducting a valuation internally
  5. Safety.  Using a (respected) third-party BV firm allows the company to feel confident in the safe harbor presumption offered by the IRS

From my parentheticals above, one might presume that I believe there are differences in quality among BV firms.  One would be correct in that presumption.

Two points:

  1. The VCs do have to report Fair Value of their underlying investments for ASC 820 Fair Value Measurements at the portfolio level, but they are not required to rely on 409A valuations to comply with ASC 820. Often VCs run their own internal valuations for their portfolios in a quarterly batch process. So again, along with the other points already made, the VCs likely care about your 409A only insofar as you (a) have it taken care of, and (b) have selected a reputable service provider.
  2. As your company matures, you may find yourself feeling differently about your 409A valuations (and service provider). The desire for the lowest supportable price may begin to seem unreasonable and inconsistent with an objective valuation. This is particularly true as you begin to contemplate secondary sales of your stock. The picture becomes more complicated; Fair Value will take on a new meaning, and you and your VCs will together want a truly objective Fair Value measurement. You will want to be sure your service providers reallyknow what they are doing.  It is here that the VCs, auditors, attorneys, founders, optionees -- not to mention the SEC and IRS -- really care about both the process and the result.

409A employs the standard of value known as "Fair Market Value" according to Revenue Ruling 59-60.  In other words, there is no difference between the "409A value" and "Fair Market Value."  This is theoretically sound.  

However, there may be cases (I would argue many cases) where a company's "409A value" was improperly calculated and therefore not an accurate reflection of its Fair Market Value.  So, while the idea that 409A=FMV may theoretically be true, the fact is that there are a lot of lame 409A providers out there that are not actually valuing companies at their true FMV.  This is a sad fact.

Right?  Many companies employ the services of third-party  firms to perform valuations for 409A.  The  theory is that an independent appraisal offers the most  effective  protection.  However, identifying professionals competent to render accurate 409A valuations remains difficult -- more difficult  than, say, identifying low-cost providers in the space.  

Over  the years, legislation has  tightened the definition of what constitutes  a qualified appraiser.   The current set of standards include the   following:

  • Regular performance of appraisals for which the individual receives  compensation;
  • Demonstration of education and experience in valuing the type of  entity subject to the appraisal;
  • An appraisal designation from a recognized professional appraiser  organization.

In  the end, there are two key elements to 409A compliance: appraiser and appraisal.  Clearly, not only  is it important to use  reputable, qualified appraisers, but it is also  critical that such  professionals follow generally accepted valuation  standards to craft  robust appraisal reports.  Without both, you are not  fully protected  from the perils and pitfalls of noncompliance with 409A.

Such provisions are increasingly common.  At Arcstone, we value share buybacks quite often.   

Assuming the founders' shares are Common Stock, and further assuming that the value of the Common Stock purchased is unreasonably high, a few problems arise with respect to IRC 409A and ASC 718.  This "unreasonably high" purchase price often occurs when current investors (or the company itself) purchases founders' shares at the current preferred stock price.  For example:

Founders Common was issued 18 months ago at $0.01
Pfd A is being sold at $1.00 per share
The 409A valuation (conducted contemporaneous with the Series A) shows $0.25 per share for Common
Founders Common is being sold (to the company or to current investors) contemporaneous with the A round for $1.00 per share

Opinions differ on this matter, but I believe a good valuation practitioner would have a difficult time valuing the common at anything other than $0.25 per share.  Assuming an exercise price of $0.01 per share, it is assumed that the IRS will interpret the facts and circumstances as the founders receiving  (1) $0.24 per share of long-term capital gains, and (2) $0.75 of ordinary income.  Currently (circa 2010), LTCG is 15%, whereas ordinary income tops out at 35%. Therefore, there is a tax advantage in holding the Founders' stock.

This is not tax advice!  And every situation is different.  You should talk to your tax attorney, securities attorney, and/or valuation pro to learn more in light of your specific situation.

Yes, there is risk of a massive price adjustment when these companies actually do disclose information.  For the uninitiated, below is an abbreviated list of atrocities currently committed in the secondary marketplace: 

  1. Buyers acquiring stock without knowledge of underlying fundamentals.  When done unknowingly, we call this tragic ignorance.  When done knowingly, we call it building a vanity position.
  2. Market participants propagating (knowingly or unknowingly) information asymmetry.
  3. Brokers collecting commissions on transactions where either (or both!) #1 and #2 are true.

To be clear, I believe SecondMarket is doing a great service to the private equity community, broadly defined, by providing a well-functioning market where private company stock can be exchanged in the light of day.  However, some (many?) participants in the market are bizarrely self-consumed and self-dealing.    

Readers should note that I have a natural partiality in my position: I founded Arcstone Equity Research in response to this very issue: information paucity in secondary market transactions.  Note also that we have partnerships with SecondMarket among others.

Marketplaces like SecondMarket are helping market participants to exchange private company shares more efficiently.  In well-performing markets characterized by a robust supply of information and research analyst support, market efficiency simply lowers friction, which of course is good.  

However, at this time (December 2010), secondary markets may not be characterized by information symmetry and robust analytical support. Quite the contrary, which is why we are witnessing incredible inconsistency in the pricing dynamics of transactions occurring in these markets. Where (1) information is insufficient and (2) supply and demand are off balance, secondary markets are increasing the velocity of transactions possibly made in poor judgment.  

As a valuation expert, I believe that the majority of transactions taking place in today's secondary markets are not reflective of  Fair Value. We recently discussed this very topic in a  monthly meeting of the Fair Value Forum (a Silicon Valley-based valuation think-tank), and I would say that a majority  -- if not an absolute union -- of my peers are in agreement with me on  that.  

Thankfully, SecondMarket is working to rectify the information asymmetry problem that characterizes so many transactions. Case in point: SecondMarket was behind a recent transaction of significant size where third-party investment research was made available to the buyers and sellers. I believe that this transaction, which was initiated and closed in less than a week (lightning-fast, given the circumstances), was successful in very large part due to the presence of information and analytical support. 

All this is not to say that secondary markets are helping to overvalue  private companies. In some cases companies are likely overvalued; in  others they are undervalued. In the future, with better information and  more robust analytical support, this market will become more transparent, efficient and well-supported.  Supply and demand will come into balance,  and the Private Company Market will be a well-functioning marketplace  for private company stock.  And, if all goes according to plan, Fair Value will be delivered.

With respect to valuation reports, three dates are important:

  1. Report Date. This is when the valuation report has been finalized and signed by a qualified professional appraiser. This date is essentially meaningless except in the rare need to track versions of the same report.
  2. Valuation Date. This is the date of  measurement for the valuation. This date is critical, as it marks the earliest date at which a stock option may be granted at the value reported. 
  3. Grant Date. This is the date at which your stock options were granted. For compliance with IRC 409A, the grant date must always follow the valuation date, though never by more than one year (or sooner in many circumstances). The Grant Date is not often stated in a valuation report.

For example:

  • Without a valuation report on which to depend, Company grants options to early employees at $0.05 per share. June 2008
  • Company hires you. July 2008
  • Company raises Series B at $1.00 per share. August 2008
  • Company begins 409A valuation process
  • Service provider renders 409A draft (conclusion: Common Stock = $0.25 per share).  Valuation Date = August 2008
  • Service provider produces final, signed 409A report.  Report Date = September 2008
  • Company grants you Common Stock Options at $0.25 per option. Grant Date = October 2008

Your stock options will be granted at $0.25 per share as of the October Grant Date, based on the August Valuation Date. 

Because the first 409A-compliant report is rendered as of August 2008, any options granted prior to that date are not within the 409A safe harbor. Thus the stock options granted to the early employees (in June 2008) are unprotected and out of compliance with respect to 409A.

Fair Market Value (FMV) refers to the age-old standard of value to which the IRS adheres. Fair Market Value has a great deal of case law behind it.   Current cases continue to support the usage of both Discounts for Lack of Control (DLOCs) and Discounts for Lack of Marketability (DLOMs) under the Fair Market Value standard.  These discounts are often relied upon when valution analysts appraise the value of limited partnerships for tax purposes.  

Fair Market Value is defined in IRS Revenue Ruling 59-60 as:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. 

Revenue ruling 59-60 goes on to say that:

Court decisions frequently state in addition that the  hypothetical buyer and seller are assumed to be able, as well as  willing, to trade and to be well informed about the property and  concerning the market for such property.
Fair Value

(FV) was defined by the Financial Accounting Standards Board (FASB), which is vested with standards-setting powers for financial reporting under US GAAP.  Fair Value is often referred to as the GAAP valuation standard, and has had  increasing relevance since the advent of ASC 718 (formerly known as SFAS 123R).  Our understanding of Fair Value has been refined by ASC 820 (formerly known as SFAS 157). 

Essentially, any aspect of financial reporting that requires valuation  must adhere to the FV standard, which is defined in ASC 820 as:


The price that would be received to sell an asset or  paid to transfer a liability in an orderly transaction between market  participants at the measurement date.

Fair Value allows DLOCs  and DLOMs, where the DLOM may be calculated using a  protective put (or other) methodology.  Fair Value -- rightly or wrongly -- is often distinguished from Fair Market Value by its reliance upon Black-Scholes, Lattice Model and other option valuation methodologies which have become more readily accepted in the many years since Fair Market Value was initially established.  

Difficulty has often arisen when valuations conducted for tax purposes (say, to value stock options under IRC 409A) are later used for financial reporting purposes (for example, to account for the cost of stock options under ASC 718).  When the latter calculations are audited, the tax valuation conducted under FMV may not be acceptable under FV.  Essentially, Fair Value has in many ways become the higher standard, at least in the field of stock option valuation.

Yes, there is a difference, and mainly it depends on what people mean by the term "valuation," because that term is basically truncated from the more exact terminology of "enterprise valuation" or "equity valuation" or other more technical definitions.

The easiest way to think about the term Market Cap is PxQ.  That is, the price per share of equity times the quantity of shares outstanding. For large-cap public companies traded on major exchanges, this measure is usually "exact" in the sense that price per share is the amount of the last settled trade, and shares outstanding is a number calculated in accordance with GAAP and is generally accepted as a fully diluted figure.  Both of these numbers are easy to reference, and so Market Cap or Equity Value are easily calculated for many publicly traded companies.  

There is another term often used by valuation and research analysts called Total Enterprise Value, which is the sum of Equity plus Debt.  For those familiar with how balance sheets work, TEV = Assets = Equity + Debt.  So if your Market Cap is $10 billion and you have another $2 billion of debt on the books, then your TEV = $12 billion.  

Simply saying that a company's "valuation" is $10 billion or $12 billion is somewhat misleading simply because the term "valuation" is not specific. Most often I assume people are speaking about the Market Cap of a company when they speak about "valuation," but this is not always the case.  As I hope I have illustrated, there is a significant difference between Market Cap and Total Enterprise Value to a valuation analyst.

A Whitepaper on the Secondary Market:

Private Company Liquidity: Fueling American Entrepreneurship

Introduction

For high growth companies, one of the most efficient and effective ways to align interests among stakeholders, and to allocate wealth among those who help to create it, is through the issuance of stock, stock options and restricted stock units. This holds true for companies at the very earliest stages of formation all the way to large, publicly traded entities whose prospects for growth continue.

Stock options are most valuable when the underlying stock can be readily exchanged in a well‐ functioning, liquid marketplace. Stock options for public market companies are the premiere example of this. For example, those employees who received stock options of publicly traded Apple, Inc. in 2003 at a strike price of $9.00 per share, and whose awards vested during the following years, have enjoyed spectacular returns on their investment of time as they have collectively built AAPL to approximately $400 per share as of this writing. This represents a $350 billion market cap, making AAPL among the most valuable companies on the planet. For the hypothetical employee, this represents an instantaneous gain of $391 per share, or 43.5 times the strike price of the stock in only eight years... [continued]

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