In the past few months an unending number of articles have been published drawing attention to the differences in the valuations obtained by some high-profile, venture-backed companies in late-stage preferred stock financing rounds and the valuations of those same companies as they hit the public markets (the particular interest being when the valuation is lower than the “post-money" value established by the preferred stock financing round). While there are a number of very interesting aspects worth covering and have already been thoroughly covered, one aspect particularly interesting to us is whether these events highlight any issues with when and how certain preferred stock financing rounds are relied upon in a 409A Valuation (the valuation estimates the Fair Market Value for common stock for purposes of establishing the exercise price for employee stock options).
First, a brief explanation of how the valuations quoted for preferred stock financing rounds is calculated, commonly referred to as the “post-money” value. Ultimately, the “post-money” valuation is the product of the new preferred stock issue price and the fully-diluted shares outstanding (includes all outstanding options and the remaining amount in the pool of options reserved for future equity awards). The calculation assigns the same value to all preferred and common stock regardless of underlying economic rights, which may be considerable. Given the purpose of the 409A Valuation – estimate the value of common stock – a more complex analysis is performed to attempt to quantify the differences in these economic rights, resulting in a different value of the subject company; however, the value of the subject company derived in the 409A Valuation will begin to converge with the “post-money” value as a potential initial public offering (IPO) is approached. Please check Post-Money Value vs 409A Valuation for a more detailed explanation of the differences.
Now, we can begin to address any potential issues with when and how certain preferred stock financing rounds are relied upon.
In a typical 409A Valuation, a valuation specialist will rely on a recent preferred stock financing round to solve for the value of the subject company (commonly referred to as a “backsolve”) that results in an amount allocated to the newly-issued preferred stock consistent with the issue price as this is assumed to be the market value (see our 409A Valuation Overview for further discussion on allocation methods). Generally, the assumption that the issue price represents the market value is appropriate and reasonable when more than one third-party investor has either invested, or expressed interest in investing, as both the buyer (investor) and seller (company) have an economic incentive in obtaining the most favorable terms and the interest from multiple buyers provides some corroborating evidence that the terms are “at-market.”
Unfortunately, the “backsolve” method is almost blindly applied by many valuation specialists anytime there is a preferred stock financing round without much consideration given to the assumption that the issue price is an appropriate and reasonable indication of the market value. However, the recent events with these high-profile, venture-back companies are illustrative examples why it may be appropriate to reconsider such assumptions; several of these examples include late-stage preferred stock financing rounds led by a single investor and/or existing investor(s), which may not meet the definition of Fair Market Value.
The International Glossary of Business Valuation Terms defines Fair Market Value as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
A transaction involving an existing investor very clearly does not meet the strict definition of being at arm’s length; however, that certainly does not rule out the possibility the terms could be considered to be at arm’s length. It does at least warrant closer consideration of the facts and circumstances of the financing and negotiation of the terms as it’s conceivable that the existing investor(s):
May have an incentive to establish a higher valuation for the company for any number of reasons (for example, setting a precedent for future financings/transactions or potentially establishing a conversion price for an outstanding note that benefits the participating investor);
May be less sensitive to the terms given existing debt/equity interests in the company (for example, the terms of a $5 million investment after investing $200 million may not have a meaningful impact on the potential returns on the total investments in the company); and/or
May be entitled to certain anti-dilution or other rights that may make the price or valuation established by the financing less meaningful (for example, an investor may be willing to agree to a higher valuation now if entitled to additional shares based on a lower valuation established in a future financing round or IPO).
While a transaction involving a single third-party investor meets the arm’s length criteria, it may still be reasonable to question the assumption that the investor represents a “hypothetical buyer” and the transaction representative of one that would occur in an “open and unrestricted market” if the investor represents the only party that expressed interest in participating in the financing at the final terms. Under such circumstances, the company arguably would not be able to raise any additional amounts at the same terms; any other investor would require a lower “pre-money” valuation and/or more onerous terms, implying a lower valuation for the company.
In practice, it may still be the best course of action to reconcile with the preferred stock financing round in the 409A Valuation; however, the above circumstances should at least be considered and may support certain adjustments within the allocation and/or discounts applied to common stock than would otherwise be appropriate for a transaction that is clearly at arm’s length with a representative hypothetical buyer. The facts and circumstances of any financing round and the associated negotiations should be thoroughly discussed between the valuation specialist and the client. Otherwise, there is a potential that the 409A Valuation will result in an “over-valuation”, which does not create any risk with regards to compliance with Internal Revenue Code Section 409A but potentially creates a perception issue with option grantees.