10 years older, 10 years wiser: The evolution of 409A
As startups stay private for longer periods of time under the support of multiple equity financings spanning several years, their common stock valuation history is likely to come under greater scrutiny in the event a public offering is pursued.
To prepare themselves and facilitate compliance with the SEC and IRS guidelines and procedures, a strong and consistent commitment to performing common stock valuations (known as a 409A) is of significant benefit. So much so that a comprehensive guide to valuation best practices was developed and updated over the past 10 years by a variety of professional interests.
Origination of the Guide
The term “cheap stock” was first used to describe equity securities issued to company stakeholders at a price less than their fair value. This difference would be most obvious during an IPO process where the SEC and all stakeholders could compare recent 409A valuations to the public offering price range. A disconnect in value progression, most typically a significant jump in valuation under IPO, would raise questions by the SEC and external auditors about the validity of prior common stock valuations. Significant valuation differences lead to questions surrounding methodology, use of selected inputs key to the valuation, and consideration of comparable market data and transactions. The underlying support for selected methodologies and inputs becomes essential to presenting concluded values.
Cheap stock became an obvious area of interest for the IRS that further highlighted the need for supportable valuations. In 2004, the American Institute of CPAs issued the first edition of “Valuation of Privately-Held-Company Equity Securities Issued as Compensation,” which became informally known as the “Cheap Stock Guide.” A task force comprising members of audit and investment firms, corporations, independent valuation firms and academia produced the guide. Valuation Research Corporation was one of the independent valuation firms to participate on the task force. The SEC and FASB also sat as observers on the task force and assisted in establishing disclosures and valuation methods that would be acceptable.
The guide established ground-breaking best practices for valuation of private company common stock, i.e. “cheap stock” valuations. The result was a new standard applicable to independent valuations that were considered reasonable and supportable by the valuation community at large. Going forward, a company’s board would significantly reduce the risk of delayed filings or inquiries from the SEC and IRS by obtaining a contemporaneous valuation from an independent valuation firm that worked with the valuation and equity security allocation methods in the guide.
In 2013, the AICPA released an updated version of the guide, produced by a similarly organized task force to the original effort. The 2013 guide is a comprehensive valuation guide with the primary focus again being equity allocation. A number of new methods and areas of discussion served to significantly advance the original ideas presented in 2004.
The original “cheap stock” issue stemmed from the fundamental disconnect between historic private company valuations that were well below an IPO outcome. Current value waterfalls and rule-of-thumb-based approaches favored by VCs systematically undervalued the common stock of companies achieving an IPO exit. After the issuance of the guide, such valuations were subject to critique and the possibility of holding up an IPO based on review by both the SEC and accounting firms. Such delays and the inability to control the timing of the offering process represent a significant risk to companies seeking to complete a public offering during a window of favorable market conditions.
Companies that traditionally consider the “cheap stock” issue for financial reporting during the SEC look-back period leading up to an IPO generally seek common stock valuations for tax purposes at a much earlier stage of development.
The main reason for this increase, of course, was the advent of Section 409A and the tax consequences for employees granted in-the-money stock options. Company boards responsible for setting the strike price on employee option grants now face the prospect of liability in the form of an employee lawsuit for not exercising due care in establishing the fair market value of the company’s stock contemporaneous with the grant.
Aggregate Enterprise and Security-Specific Values
Traditional valuation methodologies, including income and market approaches, are used to value a business enterprise as a going concern. The business enterprise is conceptually similar to invested capital; thus, an indication of enterprise value is also an indication of the value of the company’s outstanding debt and equity in aggregate.
Where an estimate of the common stock value on a per share basis is desired, a BEV (business enterprise valuation) indication is adjusted for the fair value of its outstanding debt and cash to conclude a total equity fair value. From there, the outstanding common shares should be considered in the context of all outstanding equity claims, including the outstanding equity incentive compensation (e.g., share-based payments).
The simplest example would be an equity base consisting entirely of common shares. A reasonable estimate of the per share value would be the total equity fair value divided by the number of outstanding common shares. The dilution of in-the-money equity awards would add further refinement to the estimate for fair value of the common stock.
Many private companies are financed over time by a series of equity raises involving the issuance of preferred shares that have individual economic rights and preferences that are substantive to their fair value. Such equity structures are referred to as complex equity capital structures. In order to capture the payoff profile across the equity classes, equity allocation approaches were developed and have come to serve as a standard baseline to the valuation of common stock where differing equity classes are outstanding.
Equity Allocation Methods
One of the major contributions of the guide is the presentation of different methods to allocate the total equity value of an enterprise amongst its various equity securities (normally preferred and common shares, options and warrants). It originally presented three methods: the current-value method (CVM), the option-pricing method (OPM) and the probability-weighted expected return method (PWERM).
The current-value method is based on first determining the enterprise value using one or more of the income and market approaches mentioned, then allocating that value to the various series of preferred stock based on their liquidation preferences or conversion values— whichever would be greater. This allocation method is easy to understand and relatively easy to apply; for this reason it was the method used by most firms prior to the publishing of the guide. The guide is critical of this method because it implicitly assumes that liquidity is imminent (which is not usually the case) and tends to undervalue the common stock. This method is now only considered appropriate when (i) a liquidity event in the form of an acquisition or dissolution is imminent or (ii) the enterprise is at such an early stage of development that the other allocation methods cannot be reasonably applied.
The two preferred allocation methods are the probability-weighted expected return method and the option-pricing method. The PWERM is based on modeling the allocation under different liquidity event scenarios (e.g., IPO, sale/merger, dissolution), which are assigned a probability weight. The approach is intuitive and easy to conceptualize because it is essentially a current value method applied in the future and probability-weighted. A PWERM requires two unavoidable inputs: future total equity value under a particular outcome and the timing. These unobservable inputs are likely hard to estimate and may insufficiently capture the range of future values and/or their likelihood. This difficulty is exacerbated the further out the timing of an exit scenario. Further, a risk-adjusted cost of capital must be estimated to measure a present value equivalent.
The OPM allocates value based on the “in or out” nature of equity securities in a complex capital structure. The underlying payoff profile to each equity class is the same as a call option; thus, the OPM allocates total equity value by treating common stock and preferred stock as call options on the total equity value of the company. Exercise prices reflect total equity values at which the composition of the equity classes receiving cash flows is altered. The OPM works through a series of call options defined by exercise prices until the capital structure becomes fully-diluted (converted) and all equity holders are common stock.
The OPM has become the most widely used of the allocation methods because of its conceptual merit, as well as its less complicating assumptions. The OPM can be thought of as the generalized allocation approach and will have the widest range of applicability. The result is a valuation methodology that audit firms tend to favor and is the most “auditable.”
Each of the allocation methodologies focuses on the economic rights that distinguish the equity securities issued in a complex private company capital structure. These methods do not capture the various control rights considered value contributors to the preferred shares in VC-funded companies. Preferred shares in VC-funded companies generally have both economic and control rights.
The only preferred share rights the OPM (or PWERM) can capture are the economic rights of dividends, liquidation preference, redemption and conversion rights. There currently are no generally accepted models available that capture the value of the other rights. The OPM is designed to and does a reasonable job of valuing a security in a volatile company with some downside protection and conversion rights. It is not designed to value traditional cash dividend-paying, non-convertible preferred shares. A discounted cash flow model using a market-derived discount rate is still a superior method for valuing such traditional preferred shares.
The AICPA released an updated version of the guide in 2013. Nearly 10 years of practice following the original guide’s release have led to new best practices and the evolution of previous areas of application. Some of the most significant are briefly highlighted below:
Discount for Lack of Marketability
The 2013 guide distanced itself from the use of studies based on restricted stock transactions and private stock transactions prior to an IPO citing “reliance on these studies has diminished in current valuation practice.” In place of these historical studies and qualitative methods, the 2013 guide favored the use of quantitative methods that used inputs for time (duration of restriction) and risk (volatility). The first widely used quantitative method to estimate the discount for lack of marketability (DLOM) was the protective put method (Chaffe). This method calculates the discount by comparing the value of the underlying stock and an at-the-money put option on the stock using a term input consistent with the restriction period and a volatility input to capture risk.
Protective Put Methodologies
The 2013 guide also references three methodologies as variants to the protective put method; each of the variants generally estimating smaller discounts than the protective put. The Finnerty and the Average Rate or Asian protective put models are the two most common variants and are referenced in the 2013 guide. These two methods share in their treatment of the sale of the underlying restricted stock to recognize that liquidity does not equate to selling a stock in the future at today’s price, an assumption the protective put implicitly makes.
Lastly, the 2013 guide makes reference to a differential put that seeks to distinguish marketability discounts across the equity classes of a complex capital structure. This method seeks to recognize different levels of marketability and volatility between preferred stock and common stock.
The 2013 guide presents a valuation methodology based on a recent transaction in a company’s equity as a way to imply a total equity value and impute the value of other equity securities previously issued and outstanding. This has become known as the backsolve method. This method has been in widespread practice for a number of years and is now officially presented in the 2013 guide. A market approach that typically works with an OPM, the backsolve considers the terms of all outstanding equity classes and the expected timing to a liquidity event to value the common stock while ensuring the allocation method values the recent preferred issue at its transaction price.
The backsolve is a preferred valuation method for a private company, especially when other forms of the market approach or an income approach are either unavailable or less reliable. The discount for lack of marketability may also consider that the recent financing round impounds the marketability of the preferred in its transaction price.
Finally, the other significant item presented in the 2013 guide is the hybrid method. This allocation approach allows a mix of allocation methods or scenarios that are weighted to conclude a present value. A hybrid approach is best applied when more than one form or timing of a future liquidity event is known or expected at the time of valuation. The benefit is most noticeable when the capital structure may be altered based on the form of liquidity event. Hence, an IPO that may be expected with reasonable probability in the near-term could suggest use of a fully converted capital structure, while a longer term M&A sale may best utilize the existing capital structure in an OPM. The hybrid method is more flexible and able to capture different, but reasonably probable forms and timings of exit.
In totality, the 2013 guide has codified a number of valuation methods and topics that have been in widespread use since the release of the original guide in 2004. This comprehensive valuation guide is a standard in the valuation profession and with the regulators and the accounting firms broadly. Its principles have been applied, tested and commented on for a number of years and serve as a baseline for valuation in financial reporting and tax.
Since the original guide was released, ongoing research and professional practice have solidified these methodologies and have become expected in reviews conducted by audit firms and the SEC.