See http://www.pwc.com/us/ipo for PwC’s IPO resources page. Here is the link for their press release.

How does this compare with what the VC industry is reporting? We do not have Q4 2010 results yet, but for the first nine months of 2010, the National Venture Capital Association (NVCA) together with Thomson Reuters reported that 40 of the IPOs were by venture capital (VC) backed companies. Of these companies, 21 were in computer hardware or software, semiconductors, communications, or Internet services, 11 were in biotech, medical technology, or health services, and 8 were in other categories. Overall, it appears as if VC backed companies represent about 25% of the number of IPOs.

This level of IPO activity is an improvement compared to the previous seven quarters (from April 2008 through December 2009) when there were just 13 IPOs by VC backed companies. However, it is still only half the number of IPOs by VC backed companies in 2007.

So clearly, VC backed companies are playing an important – but not dominant role is the US equity markets.

Source: News Release series by National Venture Capital Association (NVCA) and Thomson Reuters dated April 1, 2010, July 1, 2010, and October 1, 2010. NACVA’s study results may be found at http://www.nvca.org/index.php?option=com_content&view=article&id=79&Itemid=103.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner.

Original post permalink: http://banner.thebrennergroup.com/2011/2/18/is-ipo-market-momentum-benefiting-vc-backed-companies/



Two Cases: Tesla Motors and Fabrinet

Great question! However, the companies that have had their common shares trade on a pre-IPO basis (such as Facebook and Zynga) have not yet filed for IPOs. So we do not know whether their stock option grants in the months prior to an IPO will be at prices near, above, or below the levels determined in their 409A valuations.

However, looking at two relatively recent IPOs by venture-capital backed technology companies (Tesla Motors and Fabrinet), evidence of the IPO Bump can still be found. (I am not picking on them, I happened to have these companies’ SEC filings handy as I write this.) Both these companies issued stock options to employees with strike prices lower than their IPO offering prices.

Tesla Motors went public at $17.00 per share and is now trading above $24.00 per share. According to SEC filings, the company issued stock options at $6.63 per share six months before the IPO and $9.96 per share four months before the IPO.

Fabrinet went public at $10.00 per share and is now trading above $15.00 per share. According to its SEC filings, Fabrinet issued stock options at $5.75 per share in the six to eight month period before its IPO.

Those sound like pretty good Bumps.

Of course, most options are on multi-year vesting schedules. So employees won’t see any profit on their shares until they are exercised (and assuming the price of their shares does not decline).

What about Facebook?

Sharespost.com recently reported the sale of Facebook stock at a price of $20.00 per share which they equated to a $45.4 billion dollar valuation. Interestingly, according to state disclosures filed in November 2009 and January 2010, Facebook issued stock options for 27.5 million shares of common stock at a fair market value of $16.17 per share. Facebook executed a 5 for 1 stock split in October 2010, so these options would presumably be valued at $3.23 per share on a post split basis. At that time (December 2009) Sharespost.com reported a sale at $5.40 per share. According to Sharespost.com, in April 2010 the transaction price jumped to $10.00 per share and has increased since.

$3.23 to $20.00 sounds like a pretty good Bump. Of course, that depends on whether or not you believe Facebook will be worth $45 billion once it is listed on the public market. I couldn’t find any Facebook stock option disclosures that had been filed since January 2010. So I don’t know if there have been any more recent stock option grants or what their prices may be. There are press reports that a Facebook IPO may not occur before 2012. If Facebook has ceased issuing stock options, this would indicate at least a two-year period of time between the issued stock options and an IPO. So for Facebook, the IPO Bump may be on hold.

A company can always choose whether to issue stock options or use other compensation programs to provide incentives to management. However, stock options continue to be an important element of compensation for many companies. If a company does issue stock options in the months before an IPO, then the company should expect intense scrutiny by auditors and SEC staff. The perception of cheap stock issuances by the regulators threatens to dampen, if not kill, the IPO Bump.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/12/03/does-409A-kill-the-ipo-bump/

Here is a link to the document:  cheap stock whitepaper

While the focus of the document is on SEC compliance challenges for pre-IPO companies, a key risk it identifies concerns tax compliance with IRC 409A.  Additionally, in our view, the recommendations it puts forth also apply to companies contemplating an M&A exit.

The writers argue that cheap stock risks are substantial.  The key recommendation is that “The best way to avoid trouble with cheap stock issues is to avoid equity awards entirely during the 12-month period before filing your IPO.”  Although they add that this “…is not a realistic possibility for many pre-IPO companies…” the writers recommend a “second best” solution that centers on obtaining contemporaneous independent valuations, as well as including robust disclosure, in the IPO registration statement.

The writers summarize representative comments a company should expect from SEC staff.  Frankly, these comments come across as entirely reasonable, along the lines of: “Please reconcile and explain the differences between the mid-point of your estimated offering price range and the fair value included in your analysis.” 

IRS audit is the big risk

The big risks, according to the writers, center on tax compliance issues created by the SEC review process:  “If the SEC Staff requires an issuer to increase the compensation charge associated with a grant of stock options, this change indicates that, at least for accounting purposes the issuer has determined… that it has granted discount options.”  The writers then conjecture: “If by implication, these stock options are also treated as discount options for tax purposes, the options may be subject to additional taxes under Section 409A and may be ineligible for preferential…tax treatment.”  This is a big “if”.  The writers do point out that: “The IRS has issued no formal guidance on the interplay of cheap stock accounting charges and fair value for 409A…purposes” and “ Department of Treasury representatives have, on occasion, informally acknowledged that the SEC’s retrospective accounting valuation is not necessarily determinative of fair market value for purposes of Section 409A.”  The uncertainty of whether or not SEC conclusions could trigger a finding of non-compliance with 409A is the primary driver for the writers’ recommendations.  The writers also warn about the IRS’ audit initiative relating to potential 409A issues.  This IRS initiative is currently underway and is targeting 6,000 employers through 2012.  (I will write more about this initiative in a subsequent posting.)

In our view, companies contemplating an M&A exit are subject to similar (and potentially greater) risks as those faced by pre-IPO companies.  Just as a difference between an SEC valuation finding and the value at the time of a stock option grant may trigger an IRS audit risk, the difference between the selling price of the company and the price determined at the time of the stock option grants, may also trigger the interest of an IRS auditor.

Reconciling the value at exit for an M&A company to the values used for stock option grants may be complicated due to company fundamentals. In many cases, pre M&A companies are at an earlier stage of stage of development than pre-IPO companies.  Furthermore, the IPO process typically takes many months, and the potential value of the company at IPO can be included formally as part of the valuation process.  M&A transactions can progress from initial discussions to closure much more rapidly than the IPO process, and there may be less opportunity to formally consider realistic M&A exits at the time of many stock option grants.

 Even though we do not know the ultimate outcome of the IRS audit initiative, the 409A rules provide a “safe harbor” benefit.  For either type of exit, independent valuations conducted contemporaneously with stock option grants provide significant risk reduction benefits.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/10/14/valuation-challenges-aren’t-just-for-pre-IPO-companies

Many venture-capital backed technology companies raise capital in multiple rounds of preferred equity financings (Series A, Series B, Series C, etc). At each round, the lead investor estimates the value of the company and submits a term sheet that sets forth the proposed size, pricing, and terms of the new series of preferred stock.

Clearly, the company’s board of directors must evaluate whether the proposed transaction provides sufficient capital to fund the company’s business plan. The board will also consider the adequacy of the proposed price and the other terms and conditions.

Typically, the new investor quotes a post-money valuation (or pre-money valuation) which assumes that every share of equity is equal in value to the proposed price of the new preferred shares. However, as I have blogged before, this “VC valuation” may be very different than the “fair market value” estimated for 409A compliance purposes (or “fair value” as that term is used by the accounting profession). In particular, the VC valuation does not reflect the impact of differences in liquidation preferences and participation rights.

As an example, assume a company’s board is evaluating two term sheets. Both term sheets propose to raise $5 million by issuing 5 million Series A preferred shares at a price of $1 per share. Both term sheets propose a total post-money value of $15 million based on 15 million fully diluted shares outstanding. The Series A shares in the first term sheet have a 1x liquidation preference and are non-participating. In contrast, the second term sheet proposes a 2x liquidation preference and full participation.

• First consider the differences in liquidation preference. The liquidation preference refers to the priority of distribution of the proceeds from an acquisition or liquidation of the company. With a 1x liquidation, each Series A share receives $1.00 (their original issue price) when the company is sold. No other class of equity receives any distribution until the Series A liquidation preference is satisfied. With a 2x liquidation, each Series A share receives $2.00 (2 times the original issue price) before any other distributions are made. Is this example, the 2x liquidation means the Series A shareholders receive a 100% return on their investment before any other shareholder receives a penny, while the shareholders with a 1x participation receive no return but their invested capital.

• Second, consider the differences in participation rights. If a preferred share has no participation rights, then the maximum amount of its distribution is its liquidation preference. The only way the preferred shareholder can receive more per share than the liquidation preference is by converting the preferred share into common stock. However, if the preferred equity is participating, then the preferred shareholder is entitled to share in the available distribution once all liquidation preferences have been satisfied.

Let’s suppose our hypothetical company is subsequently sold for $13 million, the amounts distributed to the Series A and common shareholders will be very different depending on whether the first or second terms sheet was accepted.

• Under the first term sheet, with no participation, $5 million of liquidation preference is distributed to the Series A shareholders and the remaining $8 million is distributed to the 10 million common shares.

• Under the second term sheet with full participation, $10 million of liquidation preference is distributed to the Series A shareholders, and the remaining $3 million is distributed 1/3rd to the Series A shareholders and 2/3rds to the common shareholders. The Series A shareholders receive $11 million in total distributions, while the common shareholders receive $2 million.

As you have deduced, the second term sheet is a far better deal for the Series A than the first term sheet. Of course, other factors may be considered by the board in selecting one offer over the other (for instance, the second term sheet may be from a strategic investor which offers other benefits to the company).

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/8/9/differences-in-preferred-equity-rights

Many of our clients are venture capital backed technology companies that have been growing successfully and have commenced making acquisitions. On the one hand, they feel the ecstasy of getting their deals done. On the other hand, they must confront the agony of fair value accounting.

The Basics of Purchase Price Allocation

A company that makes an acquisition must adjust its financial statements to reflect the inclusion of the acquired assets and liabilities at their fair values. Fair value is closely related to the traditional concept of fair market value. For many items (such as cash assets, accounts receivable, and accounts payable) the determination of fair value is usually straight forward because the values recorded on the seller’s financial statements often reflect the items’ values. In the case of hard assets such as property, plant, and equipment, the market value of the assets may be different than the values carried on the seller’s books. As a result, the acquirer may have appraisals performed to determine fair value conclusions.

However, accounting principles require that the fair value of intangible assets and goodwill must also be determined. Intangible assets can include technology that was developed by the seller (or was in the process of being developed), existing customer relationships, marketing intangibles (such as trade names and trademarks), non-compete agreements, and other contractual arrangements that may be expected to generate economic benefits for the buyer, as well as other items. The extent to which the price paid for a company exceeds the fair value of the identifiable acquired assets (net of the fair value of assumed liabilities) is called goodwill.

Purchase Price Allocation studies determine the fair values of the tangible and intangible assets, as well as liabilities and goodwill.

The Challenge of Fair Value Accounting Principles

The challenge for a client is that the fair value framework entails concepts and definitions which may seem very distant from the specific business strategies and objectives that led to the acquisition in the first place. The challenge exists because the information needed to make the purchase decision is very different from the information required for fair value accounting measurement. The fair value of acquired assets (and liabilities) does not measure the value an asset to the acquirer based on what the acquirer intends to do with the asset. Instead, fair value is the value to a hypothetical “market participant” that will use the asset to its highest and best use.

Take a hypothetical example where one of our clients has just acquired a smaller relatively unsuccessful company that had developed an attractive technology. The conversation concerns the value of the acquired company’s brand name:

“We didn’t buy this company to get its brand name; we bought the company to get the technology. We thought this company was unable to build an adequate marketing and sales capability. That’s why their investors decided to exit. So obviously the brand name is worth nothing.”

The difference between value of the brand name as perceived by management and value under accounting rules may be extreme. In this case, a “market participant” might choose to utilize the acquired brand name. If so, its value would need to be quantified.

Another difference can occur when the client intends to utilize a specific asset, and expects synergies from the acquisition to produce significant economic returns. In this case, the “market participant” assumption can result in a lower accounting value than the value that is perceived by management. The fair value rules spell out “… buyer specific attributes and intent should be disregarded if different than another market participant.” (ASC 820, http://asc.fasb.org). Synergistic effects would not be included in determining the value of the asset. For instance, if the sales projections included synergies that are unique to the client and not available to other market participants, then the sales projections would need to be reduced to remove the synergies.

In summary, acquisitions require accounting and financial analysis to analyze the transaction from two different perspectives. The first perspective identifies the specific costs and benefits to the buyer – including synergistic benefits that may not be available to other potential acquirers. The second perspective is to examine the acquisition from the perspective of other potential acquirers (“market participants”), and assume each identifiable asset is put to its best and highest use.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/6/22/agony-and-ecstasy-of-fair-value-accounting/

The terms and conditions of preferred equity issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant!  While these impacts are important for tax and accounting compliance, more significantly, they determine the amount of money stockholders will receive when the long hoped-for “exit” is finally realized.

This is the third in a series of posts meant to help explain many of the typical terms for preferred equity we see in our daily valuation work.   This analysis will provide some guidance on the impact to the holders of common shares.  (There can be legal issues which also come into play, especially in contested matters.  However, this blog is not legal advice, and the specific facts and circumstances for any particular case will differ from the examples described herein).

Participation: Preferred Equity’s Share in an M&A Exit

The preferred stockholders’ participation rights (together with liquidation preferences) are key factors that determine how much, if anything, common stockholders receive in an M&A exit.

In an M&A exit, the proceeds from the transaction are generally distributed according to the priority (or seniority) of the claim.  For instance, debt and other legally enforceable obligations are either paid off or assumed by the acquirer first.  Second, liquidation preferences of preferreds stockholders are satisfied.  Finally, the residual amount remaining for distribution is distributed among stockholders (preferred and common) based on their participation rights.  In some instances, preferred stockholders share the residual amounts equally on a per share basis with common.  In other instances, the preferred stockholders do not receive any amount of the residual, or the amount may be limited to a maximum amount (a “cap”).

In general, we classify preferred equity as either: 1) fully participating, 2) non-participating, or 3) capped-participation:

• Full Participation – means the common and preferred stockholders receive the same amount on a per share (“pro-rata”) basis after the preferred stockholders received their preference amount.

• Non-Participating – means that the preferred shares do not receive any further distribution above their liquidation preferences.  In an M&A exit, the preferred stockholders typically have the right to convert their preferred shares into common stock.  However, they would lose their liquidation preference if they were to do so.  This means that the preferred stockholders will evaluate whether they would receive more per share by converting into common; if the per share distribution is greater than the value of their liquidation preference per share.  If it is, then the preferred equity will convert into common.

• Capped Participation – means that the preferred stockholders (after receiving their liquidation preference) have the right to participate on a per share basis with the common stock, however, the amount is limited (or “capped”) to a specified amount.  Typically, the cap is expressed as multiple of the original issue price.  For instance, the limit may be set at 3x the issue price.  Similar to the case with non-participation, the capped preferred stock holders have the right to convert their shares into common stock.  The preferred shares would be converted into common if the stockholder would receive more than the value of the distribution cap.

Examples

The different form of participation rights can result in very different amounts for the common stockholders (see Figure 1 – PDF).  For example, assume a company has been sold in an M&A exit, and the total amount available for distribution to stockholders is $12 million.  Further, assume the company was capitalized with 1 million shares of Series A preferred stock which were issued at an original price of $1.00 per share, with a 2x liquidation preference.  At the time of exit, there are 4 million common shares outstanding.

• Full Participation – If the preferred shares are fully participating, then each preferred share receives 2x its original price as a liquidation preference, and then receives its pro-rata share of the additional amount available for distribution:
o Series A Distribution per Share  = $1.00 x 2 + $2.00 = $4.00
o Common Distribution per Share = $2.00
o The Series A preferred receives $4 million in aggregate and the common stockholders receive $8 million.

• Non-participating – If the preferred shares are non-participating, then each preferred share receives  the greater of 1) its liquidation preference or 2) its pro-rata distribution by converting into common.  In this case, the preferred shares would receive $2.40 each by converting into common:
o Series A Distribution per Share = $2.40
o Common Distribution per Share = $2.00
o The Series A preferred receives $2.4 million in aggregate and the common stockholders receive $9.6 million.

• Capped Participation – Assume the preferred shares are subject to a 3x participation cap (total distribution per share may not exceed 3x the original issue price).  Each preferred share receives the greater of 1) its participation cap, or 2) its pro-rata distribution if it converts to common.  In this case, the preferred shares would receive $2.40 each by converting into common which is less than the amount of the participation cap of $3.00.  The preferred shares would not convert into common, and the resulting distributions are:
o Series A Distribution per Share = $3.00
o Common Distribution per Share = $2.25
o The Series A preferred receives $3 million in aggregate and the common stockholders receive $9 million.

Conclusion

Liquidation preferences together with the participation provisions are key factors in determining the payouts to stockholders in an M&A exit.  In an IPO exit, typically, the preferred stockholders are subject to automatic conversion into common and these provisions are lost.

Preferred Equity Basics Three — Figure 1 (PDF)
Preferred Equity Basics Three — Figure 1 (Word 2007)

Other Posts in this Series
Preferred Equity Basics Pt 1: VC Differences
Preferred Equity Basics Pt 2: Seniority & Liquidation Preferences

Original post permalink: http://banner.thebrennergroup.com/2010/03/29/preferred-equity-basics-3/

The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for tax and accounting compliance. But more importantly, they determine the amount of money shareholders will receive when the long hoped-for “exit” is finally realized.

This is the second in a series of posts meant to help explain many of the typical terms for preferred equity we see in our daily valuation work. Hopefully, this analysis will provide some guidance on the impact to the holders of common shares. (There can be legal issues which also come into play, especially in contested matters. However, this blog is not legal advice, and the specific facts and circumstances for any particular case will differ from the examples described herein).

Seniority: Preferred Equity Is In-Between Debt and Common Stock at M&A Exit

The preferred stockholder’s liquidation preference (together with the degree of participation) is a key factor is determining how much, if anything, common stockholders receive in an M&A exit. Participation will be the subject of subsequent blogs.

Most of the companies we see are early stage venture capital backed technology companies. They typically have a capital structure comprised of common stock, preferred stock, and occasionally debt. The exit for an investor is sometimes an IPO, but more frequently, it is a “liquidating event”, which can mean either the company is sold in an M&A exit or the company is shut down. In the case of a liquidating event, the seniority of each component of the capital structure becomes key to whether and how much of the liquidation value is received by each class of shareholder. Take, for example, a company that was funded by $20 million in preferred stock and $5 million in debt. The debt is considered to have first priority on the proceeds available for distribution from the liquidating event, typically the preferred equity has second priority on the proceeds (due to its liquidation preferences), and the common equity has whatever is left over (in this case, it stands third in line). If the company is sold for less than $25 million dollars, the debt holders would get paid off first, the preferred equity holders would get the rest (but not their entire preference amount), and the common stock holders would get nothing. The common stockholders would only receive a distribution if the company is sold for more than $25 million.

Liquidation Preference Multiple (1x vs. 2x) and Similar Provisions

In many cases, the liquidation preference is “1x”, which means the preferred equity gets one times the amount they invested. In the example above, the preferred equity put in $20 million, so the amount of their liquidation preference is $20 million.

However, a liquidation preference can be “2x” (or “3x” or some other multiple), meaning the preferred equity gets back twice the amount invested before any proceeds are distributed to common stockholders. In the example above, the preferred equity would get back $40 million.

In some cases, there may be a mandatory dividend on the preferred, or the liquidation preference is structured so that the amount of the liquidation preference grows at a specified rate (e.g., 8% per year non-compounding) until the exit event. In the above case, assuming a three-year term to exit, the liquidation preference for the preferred equity would be $24.8 million. The key point is that liquidation preferences greater than 1x mean that the common stock holder receives nothing until and unless the preferred equity holder receives a return of capital plus a specified amount of profit.

Conclusion

Liquidation preferences provide preferred shareholders with downside protection on their investment. In some cases, liquidation preferences also provide for a profit. Of course, the assurance is not absolute. At an exit, legally enforceable obligations (such as debts, lease commitments, legal judgments, etc.) must be satisfied first. However, once these first priority claims are satisfied, then the preferred stockholder is second in line and ahead of the common stockholder.

The preferences of preferred stockholders do not end with just the liquidation preference. In the next blog, I will describe what happens after the preferred stockholders receive the liquidation preference in an M&A exit through their participation rights.

Other Posts in this Series
Preferred Equity Basics Pt 1: VC Differences
Preferred Equity Basics Pt 3: Participation Rights

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/02/04/preferred-equity-basics-2/

The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for 409A compliance. But more importantly, they determine the amount of money employees may receive when the long hoped-for “exit” is finally realized.

This is the first in a series of posts meant to help explain many of the typical forms of preferred equity we see. We will provide guidance on the impact to the holders of common shares.

Preferred equity is extremely malleable, the specific terms and conditions are tailored to the facts and circumstances of each unique case. So there can be additional differences between the cases discussed here and the specific equity structure of any particular company.

Overview of Preferred Equity

Preferred equity is sometimes described as a hybrid security that combines elements of a debt security and an equity security. To the extent that the preferred equity provides for the return of principal and commits to the payment of dividends (in effect the dividend acts like an interest payment), it is similar to debt. To the extent that there may be no specific time-frame for when the original amount invested must be repaid and it participates in the growth of the company, it is similar to equity.

Venture Capital Preferred Equity is Different

In venture capital financings, the debt-like characteristics of preferred equity are changed and significantly expanded. While often there is no mandatory dividend, there are hosts of additional rights, protections, and privileges. Preferred equity issued to a venture capital firm is a highly customized security that provides the preferred investor a set of provisions (“preferences”) that are tailored to each company’s unique requirements and circumstances. Preferred stock rights often grant the preferred stockholder advantages relative to the common stockholder. The preferred equityholders may have some or all of the following rights:

o To earn a return on their investment that is disproportionate to the percentage of shares owned relative to the common,

o Downside protection, and

o To have disproportionate influence or control over the company.

Economic Rights and Control Rights

Using the terminology of the AICPA, certain provisions give the preferred equityholder economic rights and control rights: “…preferred stock has characteristics that allow preferred stockholders to exercise various economic and control rights”.[1]

Economic Rights

o Preferred Dividends – As discussed above, mandatory dividends are infrequent in the venture capital transactions we have observed. However, specific dividend rights may be granted.

o Liquidation Distributions – These rights are critical to understanding the value of common shares. These rights refer to the specific rules by which the proceeds from a sale of the company are distributed among each class of shareholders.

o Mandatory Redemption Rights – These rights give a class of preferred equity the ability to require the company to buy back the preferred shares (exit the investment) before the ultimate liquidity event.

o Conversion Rights – These rights give a class of preferred equity the ability to convert their shares into common stock at a specified conversion rate. While most conversion rates are 1:1 (one share of preferred stock is exchangeable into one share of common), we sometimes see different conversions rates such as 1:2 (one share of preferred stock is exchangeable into two shares of common). Frequently, preferred shares are subject to mandatory conversion (they must be exchanged for common shares) if the company proceeds with an IPO.

o Anti-dilution Rights – These rights give a class of preferred equity the ability to adjust liquidation and conversion rights so that dilution is either reduced or avoided due to the issuance of new shares.

o Registration Rights – These rights give a class of preferred equity the ability to compel the company to use its best efforts to proceed with an IPO (or secondary offering).

Control Rights

o Voting Rights, Drag-Along Rights, Protective Provisions, and Veto Rights. These rights give a class of preferred equity disproportionate voting or veto power over the company, or the right to compel other equity classes to vote a particular way.

o Board Composition Rights. These rights give a class of preferred equity disproportionate power to designate specific board members, or to control the board.

o Management and Information Rights. These rights give a class of preferred equity access to pre-specified information such as financial reports, company plans, and the right to attend and observe board meetings.

o Participation Rights (Future Financings). These rights give a class of preferred equity the right to purchase a portion of any future equity financing so that the original ownership percentage is maintained.

Conclusion

In subsequent blogs, I will describe how these provisions typically play out as a venture-capital backed company proceeds with its “exit” either through an Initial Public Offering (IPO) or a sale or wind-up the business. These provisions have a big impact on all classes of equity at exit, in that they determine how much of the value of the company is paid out to each shareholder.

Other Posts in this Series
Preferred Equity Basics Pt 2: Seniority & Liquidation Preferences
Preferred Equity Basics Pt 3: Participation Rights

________________________________

[1] This quote and the ensuing discussion are adapted from the AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation, Appendix H.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

Original post permalink: http://banner.thebrennergroup.com/2010/02/01/preferred-equity-basics-1/

The comments range from expressions of pain and dismay to colorful language that is not suitable for reading at the family dinner table.

For early stage companies, the burden and frustrations can be significant because of the costs and complexity of compliance. Compliance with the rules reduces the efficacy of one of the key tools early stage companies use to compensate and reward employees: low strike price options. It seems to us that the rules would be a prime target for tax reform. Some form of simplified tax treatment would lift this burden from early stage companies and their investors, and would help them to attract and compensate employees.

Speaking of tax reform, if you haven’t seen it, information about a new documentary called “An Inconvenient Tax” has been making the rounds on the blogosphere. The trailer and website actually come across as non-partisan. The film makers indicate they have interviewed individuals with a range of political viewpoints, from Noam Chomsky to Steve Forbes, economists, and others. I am not sure what the film makers are actually advocating in terms of solutions, but it would certainly be a positive if the film prompts informed tax debate and real reform.

The documentary was profiled a few weeks ago by a blog at the Wall Street Journal. Here is the link:  http://blogs.wsj.com/wallet/2008/09/22/inside-the-brain-ofthe-creators-of-an-inconvenient-tax/?mod=rss_WSJBlog 

Original post permalink: http://banner.thebrennergroup.com/2009/11/12/409A-an-inconvenient-tax/

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http://www.undertheradarblog.com/blog/5-classic-and-costly-mistakes-startups-make-with-their-people-5/

What made #5 on his list? Ignoring Internal Revenue Code 409A.

Avoid tax penalties and painful employee complications

His short note makes several excellent points. 409A has changed board practices at VC backed technology companies for setting the exercise prices on stock option grants. He points out the potential nasty tax penalties of non-compliance as well as the “safe harbors” in the 409A regulations. And he stresses the importance to the founders of startups to understand these safe harbors and the possible unpleasant side effects on optionees.

Of course, we’re in the business of providing 409A valuations in accordance with the tax code’s safe harbor provisions. But we see many boards not committed to 409A compliance, and it is a recipe for downstream pain. We can’t make 409A go away, but we can make the process of compliance a bit easier. The thing to understand is that valuation has become part of the standard accounting and tax compliance process for early stage companies.

409A compliance makes an M&A event go smoother

As Mr. Gaviria has cautioned, inadvertent problems with 409A compliance can lead to ‘…significant cost and delay when they have to be solved under the scrutiny of an acquiring company’s accountants and counsel.” I would add that the costs and delays can also occur at the point a company engages financial auditors for any reason, and the scrutiny gets more intense as the company prepares for an IPO or acquisition.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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Many people are familiar with the concept of a Discounted Cash Flow (DCF) analysis which calculates the value of a firm as the present value of its future cash flows discounted at the firm’s cost of capital. The H Model is a form of discounted cash flow analysis in which the firm’s cash flow is modeled in two stages. The first stage is a relatively short period time in which the firm is expected to experience a high rate of growth and the second stage is the long term sustainable growth rate of the firm. One of the features of the H Model is the high growth period is not modeled assuming a fixed high rate of growth, but the model reduces the growth rate linearly through the initial stage, until the long term growth rate is reached. The model also allows for the use of different cost of capital assumptions in the two stages, allowing one to model the high growth period according to a higher risk, higher capital cost profile, and then reducing the cost of capital in the second stage to reflect the expectation that the company reaches a stable level of operation and lower risk conditions.

H Model is appealing for early stage technology companies

Here’s a hypothetical example. Assume a company has commercially launched its first products or services, and develops financial projections covering a three to five year period. The projections portray the company achieving sufficient scale and profitability to proceed with an IPO at the end of the forecast period (assuming, of course, the equity markets cooperate).

The H Model allows us to model this situation according to three stages. The first stage represents the three to five years the company has projected its initial period of growth. The company may have negative cash flows for much of its first stage of development, and may be deemed high-risk, with a commensurate high cost of capital. In this first stage, we may simply rely on the cash flows contained in the company’s financial projections. The H Model is then used for stages two and three. In this hypothetical example, the H Model’s high growth stage is used to model the continued growth in cash flows following the IPO. While not within the scope of the company’s financial projections, there may be an expectation that growth will not drop off suddenly after the IPO. If cash flows grow 50% in the year before an IPO, it may be reasonable to assume that growth trends downwards for the several years following the IPO until the sustainable level is reached. The H Model’s sustainable growth stage is then used to model the value, assuming the company has achieved its full potential scale of operation and continues to grow at a long term, sustainable rate.

A key benefit of the H Model is that it appears to fit the financial history of many venture capital backed technology companies. One can exhume a company’s actual historical financial results and see a very common pattern of results. One can then see, in the first years of operation, the negative cash flows. One can observe the growth in revenues, the improvement in profitability and cash flow results through the IPO, and on into the years following the IPO.

Of course, one may also see the volatility of market value after the IPO (positive and negative), and periods of stronger and weaker financial results, rather than a halcyon existence of sustained growth.

A formal valuation would include multiple valuation models

As a final note, the applicability of the H Model is subject to the specific facts, circumstances, and expectations that are unique to each company. While the H Model is one form of discounted cash flow analysis, there are others which may also be used in any particular valuation. In general, the H Model analysis performed would also be accompanied by other valuation approaches (such as a Market Approach), as appropriate, within a formal valuation report.

The interested reader can find out more about the H Model in Chapter 4 of Financial Valuation, Application and Models, 2nd Edition by James R. Hitchner (Wiley, 2nd Ed., 2006). If the reader is in the CFA program, multi-stage cash flow valuation models are addressed in Chapter 3 of Equity Asset Valuation by John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA and Dennis W. McLeavey, CFA (CFA Institute, 2007). Some writers use the term H Model to refer to a specific dividend discount model. However, other authors apply the term more generally as a method of cash-flow based valuation, as I do here.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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http://banner.thebrennergroup.com/8/24/2009/alternate-valuation-model

In light of the turmoil in the equity markets over the past eighteen months, some have conjectured that the difference in values between public and private companies has gotten wider. An intriguing set of studies conducted by Ronald M. Seaman shine some light on this issue.

LEAPS Study Provides Insight

Seaman studied a form of stock options referred to as LEAPS (“Long-Term Equity Anticipation Securities”). These are stock options (call and put options) listed on the Chicago Board of Exchange and elsewhere, with extended terms until maturity (Seaman has studied LEAPS with maturities that have typically ranged from 14 to 30 months). Put options can be purchased by an investor to hedge against a decline in stock value. According to Seaman, “…the cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, measures the cost of price protection against a loss of value of the stock.” Seamans postures that this cost of price protection is a proxy for the relative lack of marketability.

Most notably, Seaman conducted a study of LEAPS prices in 2006 which he has updated with prices measured in November 2008. The changes in discounts between these two periods of time are eye-opening. Obviously, equity markets in 2006 were relatively benign, while the markets in November of 2008 were in a state of extraordinary turmoil. For instance, Seaman found that the median cost of price protection for companies with revenues less than $100 million went from 27.3% (for 18 month terms) in 2006 to 47.2% (for 14 month terms) in 2008. Overall, Seaman observed, “Discounts in November 2008 were double or greater the discounts in October 2006”.

The use of options models (and the supporting LEAPS studies) has been gaining increasing visibility as a method for quantifying DLOMs used in valuation studies. At a minimum, evidence of the kind supplied by Seaman challenges the analyst to consider both company specific facts and circumstances, as well as the overall economic climate and equity market conditions, in the determination of marketability discounts.

(The source of all quotes is “Minimum Marketability Discounts”–4th Edition, A Study of Discounts for Lack of Marketability Based on LEAPS Put Options in November 2008 by Ronald M. Seaman, FASA, March 2009. A copy of the study may be obtained at http://www.dlom-info.com/)

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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In a nutshell, the numbers are developed for two different purposes and should not be expected to be the same or even similar.

The venture capitalist is interested in structuring a financing. Typically, venture capital financing is provided in the form of preferred equity. The post-money valuation is used to determine the price of each preferred share. Typically the post-money value is calculated by multiplying each share (regardless if it is common or preferred equity) by the price of the preferred share. However, a preferred share is typically worth more than a common share because of its liquidation preference and other rights and privileges.

Investors buy preferred stock, insiders get common stock

In a simple example, a venture capitalist may determine a company has a $10 million pre-money valuation, makes a $5 million dollar investment, and receives ownership of one-third of the total shares (preferred and common) in the company with a post-money valuation of $15 million. The VC’s one-third interest, however, will be in the form of preferred equity. The two-thirds interest held by the founders and management will be in the form of common equity. To keep the example simple, assume each preferred share was priced at $1, then the VC would hold 5 million preferred shares and the other shareholders would own 10 million common shares.

If the company ultimately proceeds with an IPO, typically the preferred shares are automatically converted into common so that the VC would end up with one-third of the ultimate value and the other shareholders with two-thirds.

Preferred stock’s preferences can make them worth much more than common

However, if the company is acquired by another firm, the preferences become important. For instance, in the case of participating preferred equity, when the company is sold the preferred investors receive their liquidation preference which means they get back their original investment first. The remaining amount is then distributed among all equity holders, preferred and common, on a pro-rata basis. If the company is sold for $20 million, the VC will first receive its $5 million liquidation preference as well as one-third of $15 million for a total of $10 million. And the other investors will receive two-thirds of $15 million for a total of $10 million. In this example, the VC’s one-third interest results in receiving 50% of the value.

Preferred equity’s rights and privileges can go far beyond the simple liquidation preference described above and can include mandatory redemption rights, anti-dilution rights, voting rights, board seats, and other factors.

The result is each preferred share is worth a lot more than a common share. For instance, assume each common share is worth 30% of the price of the preferred equity. (This is just an illustration; the actual differential for a particular case is dependent on specific facts and circumstances and may be quite different than 30%. In some cases there may be no difference).

Put another way, if the company approached a hypothetical third party and asked whether they would pay $1 for a preferred share based on the VCs investment, many investors would say yes. But they would not be willing to buy a share of common in the company for a $1. In the real world, there are typically no financial investors willing to pay anything for the common in the early stages of a company’s development. However, founders, friends and family, and employees are often willing to take common equity as a portion of compensation (such as founders’ shares or stock options). And so some degree of value may be attributable to the common.

Assuming this applies to the simple example above, the VC would own 5 million shares worth $1 per share (total worth $5 million), and the other investors would own 10 million common shares worth $0.30 per share (total value $3 million). In other words, the value of the company would be $8 million dollars – a far cry from the $15 million post-money value.

Independent valuations more accurately determine the value of each class of stock

Fair market value (for 409A tax compliance purposes) and fair value (for FAS123R purposes) are closely related terms meant to reflect the value of the company and its common and preferred equity, on the basis of independent, arms length transactions.

A key result of a valuation of an early stage company for 409A and/or 123R compliance purposes is to determine just how much less the common shares are worth relative to the preferred shares. The techniques used are designed to quantify the ultimate payouts to each class of equity under a variety of exit scenarios and to determine the relative value based on the probability of each exit scenario occurring.

Over time, as the company grows in total value, the relative value of the preferred and common shares may ultimately converge.

In summary, the post-money valuation assumes all classes of equity are worth the same. In this case, each share of common and preferred is worth a dollar. In contrast, fair market value reflects that in the early stages this is unlikely to be the case. Instead, the common is likely to be substantially discounted relative to the preferred. As a result, the total value of a firm under a fair market value or fair value standard is likely to be substantially less than the stated post-money valuation.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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We will sometimes select one method’s result for our final conclusion of value, sometimes we will use an average of results, and sometimes we will weigh the results and use a weighted average.

In a perfect world, each method should be expected to come up with a result that is very close to the others. And for companies with established business models, this is frequently the case.

Valuations of early stage companies can vary dramatically

However, for early stage technology companies, this is not always the case. These companies are often characterized by a distinct absence of revenue or other metrics of customer validation. They are often not profitable, and if showing accounting profits, they may still be significantly cash flow negative. Financial projections (if available) may be purely speculative, reflecting management’s hopes rather than expectations. The public companies in their industries are typically much more mature. New entrants are often trying to disrupt and change their industries with new business models.

The selection of a particular set of weightings for any particular valuation depends on an assessment of the quality of the data (the evidence) upon which each analytical method relies, and the degree of similarity of the subject company to the other companies used as a basis of comparison. If there are recent transactions in the company’s common or preferred stock, these transactions can be used to help reach a conclusion of value. Other factors may also be considered.

Using weighted averages is an acceptable valuation practice

The simple averaging of results can be reasonable and acceptable. For instance, Rosetta Stone, Inc. disclosed in its SEC filings that its valuation firm used the simple averaging of the results from different valuation methodologies in the valuations it performed in the three years prior to IPO:

“We considered numerous objective and subjective factors in valuing our common stock at each valuation date in accordance with the guidance in the AICPA Practice Aid Valuation of Privately Held Company Equity Securities Issued as Compensation. For each common stock valuation that we performed, we determined the fair value of our common stock by taking the average value calculated under the discounted cash flow method, the guideline method, and the comparative transaction method. We weighted each method equally.” (page 51, SEC submission filed pursuant to Rule 424(b)(4), dated April 15, 2009).

However, each company’s circumstances are unique. The weighting of results will need to be considered in each valuation performed.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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http://banner.thebrennergroup.com/5/5/2009/weighing-in-on-business-valuations/

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The easiest answer in this case is for the projections to be the same. The next best thing is a high level of consistency and continuity among projections. The company should have a “master set” of projections adopted by the board as the official plan of the business and which is also used for tax and accounting compliance.

Maintain Continuity and Establish a Process
Unfortunately, the easiest answer is not often the feasible answer. The typical early stage technology company undergoes change at breath-taking speed, frequently making rapid and significant changes to its product, marketing, and sales strategies, as well as sourcing and operational capabilities. The current period of economic turmoil has exacerbated this situation placing financial and cash flow constraints upon many companies. The result: companies may explore and evaluate a broad set of alternative plans, budgets, and financial scenarios on a continuous basis. Not every version will be formally presented to the board or to investors. The projections used for valuation purposes may be very different than the last set of projections presented to the board.

One solution is to create and maintain financial projections in a two-phased process. In the first phase, management memorializes its current expectations for revenues, expenses, compensation, and all other key elements that make up its financial plan and prepares an official version of the company’s financial projections. In the second phase, these projections are presented to the executive management and to the board and are used as a key input to the 409A valuation study. Of course, the valuation specialist may still choose to adjust (or “normalize”) the results as part of the 409A valuation study. However, the audit trail is now clear and will be traceable by all, including that skeptical auditor.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst designation and is a member of the CFA Institute and the CFA Society of San Francisco.