Experience matters

In 1987, we were in a period when many of the younger investors had great educational credentials and could analyze how much to invest in a specific sector, but they lacked enough operational experience to understand what to do when the business was not succeeding. Many of the venture partnership funds were coming to the end of the lives of specific partnerships, and decisions on disposition needed to be made. If this sounds familiar, the same thing happened after the dot.com bubble broke, and again after 2008. Liquidity has become a big challenge even for successful companies, and thus many funds are again faced with critical decisions on how to gracefully exit companies that in good times could have had successful exits.

A memorable client

I remember one of our first clients, which was a little fair afield of technology businesses. We were called in to help a national RV dealership that had started the IPO process, only to find out they were almost out of business when the 1987 recession became a reality. They filed bankruptcy, and that is when we were called in by the debtor’s counsel. No one had been able to determine what the debtor’s financial status really was, as it appeared to be a moving target.

After analysis, we determined that the founder and his son had actually embezzled funds from the company. When I informed them they should not come back to the office, the son came back with an assault rifle to “take care of the guy who had fired him.” The federal Judge later said, “Mr. Brenner, I am not paying you enough for hazardous duty. Are you sure you can continue?” We did continue, and tried to find all of the money they had taken, which was in offshore bank accounts. This is clearly one of the most interesting memories over the past 25 years.

A difficult founder

Another interesting client was in the mid 1990′s, when we received a call on a Sunday from a large VC investor regarding a software company that the board thought was preparing for an IPO. The board had wanted to change CEO’s, but had to deal with a difficult founder. They had waited until the company needed a bridge loan to get to the IPO before telling the founder that the only way they would put more money in was for him to step aside as CEO, and serve as Chairman. We were asked to step in as interim CEO.

Once we got in, we found that the founder would try to undermine anything we tried to do, and that the company was far from any successful exit. The company had stuffed its customer pipeline full of product to the point that the distribution network had stopped paying for any inventory until it had sold through to their retail outlets. The average days sales outstanding in their accounts receivable was close to 200 days, and this was the reason they had run out of cash. When speaking with the customers in the channel, we found out the products just weren’t selling through to end customers. In the end, what was supposed to be an interim CEO position while the board looked for a CEO to take the company public, became an interim CEO position to salvage what we could, and sell the pieces of the business to interested buyers.

The last part of this story which is interesting is that the founder was needed when speaking with potential buyers of the software to explain the code, and the roadmap for the future. On the way to a major meeting with Microsoft, he informed the investment banker and me that no one would buy this piece of software because it was poorly written, and obsolete. But, he added, he could put a syndicate together to take it off our hands. At the end, one of the products was sold to a successful company for a reasonable amount, but the piece the founder wanted was sold to him for a very low sum, as he was never able to help us sell the technology.

A gratifying success story

I recall being called in to help a fabless semiconductor company. The company had been trying to develop too many different products, and had used about half of their available cash. The board decided that the company should focus on just one product, and one product only. We were asked to oversee the general operations and spending for the company. We immediately reduced their headcount by 80%, and brought their burn rate down from over $1 million per month to just over $150K per month. Then whenever someone wanted to spend money, we were the final say on whether it was necessary to complete the first product.

The first product was publically announced about 9 months after we started, and began shipping about 3 months later. Because of the low cash burn rate, the company was profitable within 4 months of shipping the first parts, and went public on NASDAQ 12 months later. When our assignment ended, the board passed a resolution stating The Brenner Group had single-handedly saved the company, and gave us a very nice bonus of shares in the public company. Clearly, this was a shining moment for our firm in our history.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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In this post, we will discuss the definition of a qualified appraiser.

A qualified appraiser is an individual who meets all the following requirements:

1. the individual either:

a. has earned an appraisal designation from a recognized professional appraisal organization for demonstrated competency in valuing the type of property being appraised, or

b. has met certain minimum education and experience requirements. For real property, the appraiser must be licensed or certified for the type of property being appraised in the state in which the property is located. For property other than real property, the appraiser must have successfully completed college or professional-level coursework relevant to the property being valued, must have at least 2 years of experience in the trade or business of buying, selling, or valuing the type of property being valued, and must fully describe in the appraisal his or her qualifying education and experience;

2. the individual regularly prepares appraisals for which he or she is paid;

3. the individual demonstrates verifiable education and experience in valuing the type of property being appraised. To do this, the appraiser can make a declaration in the appraisal that, because of his or her background, experience, education, and membership in professional associations, he or she is qualified to make appraisals of the type of property being valued;

4. the individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the 3-year period ending on the date of the appraisal; and

5. the individual is not an excluded individual.

In addition, the appraiser must complete Form 8283, Section B, part III. More than one appraiser may appraise the property, provided that each complies with the requirements, including signing the qualified appraisal and Form 8283, Section B, Part III.

Who is an excluded individual?

The IRS excludes several individuals from being a qualified appraiser that may have a direct or indirect conflict of interest.

Specifically, the following persons cannot be qualified appraisers with respect to particular property:

1. the donor of the property, or the taxpayer who claims the deduction;

2. the donee of the property;

3. a party to the transaction in which the donor acquired the property being appraised, unless the property is donated within 2 months of the date of acquisition and its appraised value is not more than its acquisition price. This applies to the person who sold, exchanged, or gave the property to the donor, or any person who acted as an agent for the transferor or donor in the transaction;

4. any person employed by any of the above persons. For example, if the donor acquired a painting from an art dealer, neither the dealer nor persons employed by the dealer can be qualified appraisers for that painting;

5. any person related under section 267(b) of the Internal Revenue Code to any of the above persons or married to a person related under section 267(b) to any of the above persons (i.e., family members, fiduciaries and beneficiaries of a trust); and

6. an appraiser who appraises regularly for a person in (1), (2) or (3), and who does not perform a majority of his or her appraisals made during his or her tax year for other persons.

In addition, according to the IRS guidance, a person is not a qualified appraiser for a particular donation if the donor had knowledge of facts that would cause a reasonable person to expect the appraiser to falsely overstate the value of the donated property. For example, if the donor and the appraiser make an agreement concerning the amount at which the property will be valued, and the donor knows that amount is more than the fair market value of the property, the appraiser is not a qualified appraiser for the donation.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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1. What is a Qualified Appraisal?

A qualified appraisal is an appraisal document that:

- is made, signed, and dated by a qualified appraiser in accordance with generally accepted appraisal standards;

- meets the relevant requirements of Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902 (available at www.irs.gov/irb/2006-46_IRB/ar13.html);

- relates to an appraisal made not earlier than 60 days before the date of contribution of the appraised property;

- does not involve a prohibited appraisal fee; and

- includes certain information.

The qualified appraisal must be received before the due date, including extensions, of the return on which a charitable contribution deduction is first claimed for the donated property. If the deduction is first claimed on an amended return, the qualified appraisal must be received before the date on which the amended return is filed.

2. What is a prohibited appraisal fee?

Generally, no part of the fee arrangement for a qualified appraisal can be based on a percentage of the appraised value of the property. If a fee arrangement is based on what is allowed as a deduction after Internal Revenue Service examination or otherwise, it is treated as a fee based on a percentage of appraised value, rendering disqualification of the appraisal.

3. Information included in qualified appraisal:

A qualified appraisal must include the following information:

1. a description of the property in sufficient detail for a person who is not generally familiar with the type of property to determine that the property appraised is the property that was (or will be) contributed;

2. the physical condition of any tangible property;

3. the date (or expected date) of contribution;

4. the terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor that relates to the use, sale, or other disposition of the donated property, including for example, the terms of any agreement or understanding that:

a. temporarily or permanently restricts a donee’ s right to use or dispose of the donated property,

b. earmarks donated property for a particular use, or

c. reserves to, or confers upon, anyone (other than a donee organization or an organization participating with a donee organization in cooperative fundraising) any right to the income from the donated property or to the possession of the property, including the right to vote donated securities, to acquire the property by purchase or otherwise, or to designate the person having the income, possession, or right to acquire the property;

5. the name, address, and taxpayer identification number of the qualified appraiser and, if the appraiser is a partner, an employee, or an independent contractor engaged by a person other than the donor, the name, address, and taxpayer identification number of the partnership or the person who employs or engages the appraiser;

6. the qualifications of the qualified appraiser who signs the appraisal, including the appraiser’s background, experience, education, and any membership in professional appraisal associations;

7. a statement that the appraisal was prepared for income tax purposes;

8. the date (or dates) on which the property was valued;

9. the appraised fair market value on the date (or expected date) of contribution;

10. the method of valuation used to determine fair market value, such as the income approach, the comparable sales or market data approach, or the replacement cost less depreciation approach; and

11. the specific basis for the valuation, such as any specific comparable sales transaction.

The Pension Protection Act also adds the notion of a qualified appraiser. We will discuss the necessary qualifications in the next blog post.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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As the name implies, inside rounds are rounds of investment by existing investors, versus outside rounds that are led by new investors.

In our valuation practice, we are often confronted with clients having gone through inside rounds, and we need to make a determination if the pricing of those investments provides an indication of value of the equity of a company (regardless of which class of shares; but usually invested as preferred equity). Each case is different, but often such an investment is not a good indicator of value as it lacks arm’s length characteristics.

Although Broughman and Fried only cover a very limited geography (Silicon Valley), a very limited time frame (companies that were sold in 2003 and 2004), and had very specific exit circumstances (M&A), it provides a welcome quantitative analysis of such inside rounds.

The study tries to answer two questions:

1. Are inside rounds (ab-)used by venture investors in order to dilute founders?

Broughman and Fried’s analysis suggests otherwise: inside rounds were mostly used when outside financing was not available. Inside rounds were often flat or down rounds, outside rounds were often up-rounds. Companies using inside financing were less likely to return a profit to their investors. In those cases, the valuation would really not have mattered to the founders, given that any proceeds were first and foremost used to satisfy the liquidation preferences embedded in venture investor’s preferred stock. This analysis seems to be confirmed by the founders’ assessment: in all cases, the inside round was used as a backstop when outside financing was not available.

2. Are inside rounds overpriced or underpriced?

The authors analyze the valuations used in the inside as well as outside financings in their sample and compare those with the ultimate sales price of the target company. Not a perfect measure by any means, but the results are striking: the last inside round valuation was up to six times higher than the ultimate sales price for companies receiving inside rounds, with a median of about two times. Companies with the last round being an outside round had pre-exit financing round valuations of up to two times higher than the ultimate sales price, with a median closer to one times. We’ve summarized this in the following table:

And why would inside rounds be overvalued?

The authors propose several reasons why inside rounds may be overvalued:

1. Litigation risk: VCs can avoid litigation from disgruntled and diluted founders by overvaluing their follow-on round

2. Signaling: An inside flat round looks much better to the limited partners of a VC than an outside cram-down round. And after additional development milestones are met, it is much easier for the company to fundraise, even if the last was from existing investors.

3. Reduce down-round cost: Staying with a flat inside round avoids triggering anti-dilution provisions, and may eliminate the need for topping off the management option pool, which would lead to additional dilution.

4. Over-optimism: VCs need to be optimists by nature in order to invest in fledgling start-ups. They might as well be optimistic when it comes to pricing their current investments and dismiss an outside investment that comes in “too low”, i.e., carries too much dilution for them.

The study has a number of limitations, foremost its small sample size. Yet it provides some genuine evidence that not all investment rounds are created equal, and that inside rounds may indeed come with a valuation bias of being overpriced.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Master’s Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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• Zillow, Inc. provides online real estate information. Its IPO occurred on July 20, 2011 at a price of $20.00 per share. The price about one week later was $32.37. Holders of stock options granted in the 18 month period preceding the IPO received positive bumps relative to its issue price. Stock options granted March through May 2010 had exercise prices of $3.25 per share (16% of the issue price). Options granted in March 2011 had exercise prices of $3.89 per share (less than 20% of the issue price). Options granted in May 2011 (two months prior to the IPO) had exercise prices of $6.33 per share (32% of the issue price).

• SkullCandy, Inc. manufactures and distributes headphones. Its IPO occurred on 7/20/2011at a price of $20.00. The price about one week later was $19.70. Holders of stock options granted in May 2010 had an exercise price of $10.32 per share (52% of the issue price). Holders of stock options granted in November 2010 had an exercise price of $12.00 per share (60% of the issue price). Holders of stock options granted in the first quarter of 2011 had an exercise price of $16.42 per share (82% of the issue price).

• Pandora Media, Inc. is a personalized radio service on the Internet. Its IPO occurred on 6/15/2011at a price of $20.00. The price about five weeks later was $15.02. Holders of stock options granted in the fiscal year ending January 2011 had an average exercise price of $2.16 per share (11% of the issue price). Holders of stock options granted in the quarter ending April 30, 2011 had an exercise price of $5.67 per share (28% of the issue price).

• Solazyme, Inc. provides plant based petroleum products. Its IPO occurred on 5/27/2011at a price of $18.00. The price about eight weeks later was $22.07. Holders of stock options granted in the calendar year 2010 had an average exercise price of $4.09 per share (23% of the issue price). Holders of stock options granted in the quarter ending April 30, 2011 had an exercise price of $8.62 per share (48% of the issue price).

IPO Bumps are not necessarily a guarantee of instantaneous riches. Most stock options are subject to vesting limitations over several years (usually four years), so any grants in the period preceding an IPO do not lead to an immediate windfall for the option holder at IPO. The employee will only receive the incremental value if the company itself is able to grow in value in the years after the IPO. Yet the evidence suggests that stock options continue to be an important element of compensation, providing the potential for strong ultimate payouts to the lucky (or hardworking) few who successfully steer their companies towards an IPO exit.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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IRC 409A requires the company to estimate the fair market value of its stock at the time of an option grant. As a venture capital backed company grows successfully and starts aiming for an IPO exit, the fair market value of the stock should grow as well, in theory. If the company had perfect foresight, the discount relative to the IPO price should decrease the closer the company gets to an IPO.

One comment first: most stock options are subject to vesting limitations over several years (usually four years), so any grants in the period preceding an IPO do not lead necessarily to an immediate windfall at IPO. The employee will only receive the incremental value if the company itself is able to grow in value in the years after the IPO.

Based on several recent IPOs, experience indicates the IPO Bump appears to be alive and well. I looked at SEC filings by LinkedIn, ZipCar, Boingo Wireless, and Freescale Semiconductor, as well as their traded prices as of June 7th:

• LinkedIn Corporation operates an online professional network designed to help members find jobs, connect with other professionals, and locate business opportunities. This company’s IPO occurred on May 24, 2011 at a price of $45.00 per share. The price two weeks after the IPO was $77.82. In addition to the increase in value since its debut, holders of stock options granted in the two years preceding the IPO received impressive bumps relative to its issue price: stock options granted two years before the IPO had exercise prices of $2.32 per share (5% of the issue price). Options granted one year before the IPO had exercise prices of $6.20 per share (14% of the issue price). Options granted about 3 to 4 months before the IPO had exercise prices of $9.63 per share (44% of the issue price). [The Brenner Group has provided valuation services for LinkedIn.]

• Zipcar, Inc. operates a car sharing network that provides self-service vehicles that are located in reserved parking spaces throughout the neighborhoods where its customers live and work. This company’s IPO occurred on April 19, 2011 at a price of $18.00 per share. The price seven weeks later was $21.54. Holders of stock options granted in the two years preceding the IPO received positive bumps relative to its issue price: stock options granted two years before the IPO had exercise prices of $5.10 per share (28% of the issue price). Options granted one year before the IPO had exercise prices of $8.74 per share (49% of the issue price). Options granted about 3 to 4 months before the IPO had exercise prices of $11.90 per share (66% of the issue price).

• Boingo Wireless, Inc. provides mobile Internet access service through wireless fidelity (Wi-Fi) networks. This company’s IPO occurred on May 9, 2011 at a price of $13.50 per share. The price five weeks later had declined to $8.87. Holders of stock options granted in the two years preceding the IPO received positive bumps relative to its issue price: stock options granted two years before the IPO had exercise prices of $1.40 per share (10% of the issue price). Options granted one year before the IPO had exercise prices of $2.85 per share (21% of the issue price). Options granted about 3 to 4 months before the IPO had exercise prices of $8.50 per share (63% of the issue price).

• Freescale Semiconductor Inc. provides semiconductors, microprocessors, and similar electronic devices for automotive and telecommunications products. This company’s IPO occurred on June 1 2011 at a price of $18.00 per share. The price one week later was $18.12. Holders of stock options granted in the first quarter of 2011 received a positive bump relative to its issue price: stock options granted three to five months before the IPO had an average exercise prices of $12.69 per share (71% of the issue price).

Stock options continue to be an important element of compensation. However, as demonstrated in the discussion above, not all IPOs result in an IPO bump for all option grants. It should not be assumed that every IPO provides a guaranteed bump in value to the employees that receive options in the period before the IPO. The recent IPOs discussed in this blog would suggest the IPO Bump is still with us, although the magnitude of the benefit can vary significantly from IPO to IPO.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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1. Institutional buyers are very cautious, and their liquidity might still be an issue.

2. These are still young companies and need more time to cement their business and financial models and don’t need the distraction.

3. They don’t really need to go public.

1. Cautious institutional buyers

This may be the biggest factor preventing more tech IPOs from going out. Despite the improved market, institutional buyers are wary of making the same mistakes they made over a decade ago when dozens of unproven, high risk internet companies went public priced at untenable multiples, only to later evaporate with the NASDAQ meltdown.

It is possible they are demanding more proof of predictability and sustainability even from the big names before they participate and that’s not bad thing. Companies like Twitter and Pandora, in the news every day, have not proven their model sufficiently to raise money through the IPO process. Yet, underwriters and probably many investors may be willing to take a chance with an IPO from these companies because of the “coolness” of their services. But will they be able to develop a sustainable business model? One hopes so.

Larger companies like Facebook, the 800 pound gorilla that everyone is waiting for to set a trend, has a much different issue. Based on its shares trading through private transactions, the company is valued at ~$80 billion. Let’s assume that Facebook sells 15% of their company in an IPO. That means the investors have to have liquidity in the range of $1.2 billion at one time. And if the investors do have that much liquidity, what will Facebook do with that much cash? Then add in the IPO for LinkedIn, Pandora, Twitter, Groupon and Zinga, which combined might account for another $10 billion, and the problem of liquidity for institutional investors becomes even larger. Where will this money come from?

One solution might be for some of these companies to consider remaining private, and continuing with the private transactions for their securities until they reach a number of shareholders (currently 500) which requires them to become an SEC registrant under the ’33 Act. Then, their shares will effectively become “registered” and there would be a more liquid market for trading in these companies.

2. Still young

Just as in #1 above, many of these companies, though well known and widely used, may not have established enough of a predictable history of profitability to permit a successful IPO. For some like Pandora and Twitter they have not reached sustained profitability or positive cash flow yet, and their business model does not seem to answer the question of when and how. So fortunately their management and investors, with probably some urging of institutional buyers, are opting to focus on making their companies more IPO-ready. And despite their billion dollar market values these are still young, evolving companies in rapidly changing markets. We applaud that decision, a tough one given the temptations of having a hot company. Similarly spending millions on preparing for an IPO and then managing a public company would be huge non-positive distractions and drains for management and boards.

3. They don’t need the money

Historically the # 1 reason companies went public was their ability to raise ample private capital at healthy valuations. However, in the case of many of these successful internet companies, raising additional capital is not the primary driver. These companies have been able to raise significant institutional money at healthy valuations. With huge valuations, these companies would need to sell many billions of dollars of stock just to get enough float to support a public market, which is more capital that they need for the foreseeable future. In addition the emergence of secondary markets and exchanges for private company stock has relieved the investors, officer and employee liquidity pressures that are often serve as an additional driver to an IPO.

So in summary, with the costs of going and being public so high and the need for capital and liquidity diminished, these big names are focusing their attention on their core business, intent on further refining and solidifying their growth path, profit model, and predictability. As such if and when they go public, they’ll be that much more attractive an investment for institutional and individual shareholders alike. It just may not be in 2011.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Several positive indicators underscored that sentiment: rebounding stock market, low interest rates and a poor real estate market suggesting that growth stocks could be attractive investments, several big name private companies were raising institutional funds at billion dollar valuations, and anecdotally the local law firms all spoke to the resurgence in their S-1 filing activity and often referred to a healthy “IPO pipeline”. So confidence in a tech IPO resurgence was high. But with a third of the year gone, there have been few notable IPOs and while activity is up over 2010, we’ re not seeing the kind of breakthrough IPO activity including the big name consumer internet players that most had expected. What happened?

A little VC history – the 80’s and 90’s

In the glory years of venture capital which led up to the dot bomb bubble, typical VC backed tech companies were able to reach successful liquidity events in 4 – 6 years. Today, that number is much higher, if it ever comes at all.

As part of this change, the definition of a successful liquidity event shifted from IPOs to M&A because there has been no significant public appetite for new tech company offerings for over a decade. What caused this, and will it improve?

In the early 1980’s, there was a rash of VC backed IPO’s, and most VC’s felt it was a natural occurrence to have one of their companies achieve an initial public offering, providing liquidity and large returns to the investors in the companies. By the mid to late 1980’s the IPO market had gotten a little cold, and there were significantly fewer IPO’s in the second half of the decade compared to the first half.

By the early 1990’s VC’s became more stringent about their investment opportunities, and focused on fewer companies with larger amounts of venture capital required. VCs looked at their portfolio and targeted a successful IPO with about 1 out of 5 portfolio investments. That one would be enough to more than outweigh the other 4 unsuccessful ventures, and still provide significant returns.

As the decade of the 1990’s progressed, many technology models (e.g. fabless semiconductors) had matured to the point where capital efficiency was lost. Without capital efficiency, VC’s could not rely on the returns they had become accustomed to, and began to look for other, more capital efficient investments. Enter the dot.com bubble.

The dot com phenomenon

By the late 90’s VC’s began to see very capital efficient businesses that appeared to grow out of nothing into companies, where success was measured in large part on “eyeballs” and not actual revenue and profitability. They believed that revenue and ultimately, profit, should follow the growth in “eyeballs”. We all know how this story ended in 2001. But in the intervening years, there were hundreds of companies which went through an IPO process, only to go out of business a year or two later.

Exacerbating the huge number of failed dot.com companies were companies like ENRON, who bilked their shareholders out of fortunes. So, on top of the public being worried about large scale fraud such as ENRON, the public had to deal with all the speculative investments that were now going out of business. So, enter the governmental regulations from Congress and the Securities and Exchange Commission. The Sarbanes Oxley legislation in 2001 was to overhaul what public companies had to do to earn the trust of the investors again. And the price tag to earn this trust was very high.

Cost of being public exploded

The costs of being a public company, complying with all of the regulations and reporting requirements, rose to several million dollars per year! How many early stage tech companies can afford that much cost coming right out of earnings in their formative years? So, by 2009, there were fewer than a dozen VC backed tech IPO’s in the entire year. And 2010 wasn’t much better. The prediction for 2011 is still better than 2010, but nothing like the glory years leading up to the dot.com bubble.

So, the issue of the cost of being a public company together with the lingering doubts in the mind of individual and institutional buyers has continued to depress the market for public offerings. Yet it is generally accepted wisdom that there are a several well known companies rumored to be teed up for an IPO and, if successful, might well reignite the IPO fever which we saw in the 80’s and 90’s. Web 2.0+ companies like LinkedIn, Facebook, Zynga, and Groupon all have proven profitable business models which can sustain a public company. Moreover their valuations are reportedly all in the billions. Only LinkedIn seems poised and ready to go public. The other big names, and many others, have not gone out and may not in 2011—how come? What’s the hold-up? My next post will examine the reasons these big names have not taken the big leap.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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An interesting speech during the annual AICPA National Conference on Current SEC and PCAOB Developments in December 2010 picks up on some of the issues surrounding derivative accounting for ASC 815 (aka FASB 133). For a good summary of the conference, see KPMG’s Issues In-Depth or Grant Thornton’s New Development Summary.

Amongst other tidbits, the SEC commented on the analysis and valuation of embedded conversion options and freestanding warrants. Similar comments can be observed at this SEC presentation dated November 2010.

The SEC admits that it is indeed a complicated path to determine the appropriate accounting for such instruments. It makes several observations:

1. They continue to encounter registrants who fail to appropriately apply the guidance relating to derivative accounting. This may not be surprising given the complexity of the subject matter, but this failure may lead to comment letters from the SEC and embarrassing re-statements of financial information.

2. More specifically, the SEC remarks cite a failure to consider all the different settlement provisions and features contained in such instruments and their impact on the accounting treatment (i.e., “down-round protection” – a rather common feature that has been explicitly mentioned in FASB’s EITF 07-5, making the instrument “not indexed to an entity’s own stock” and hence should be presented as a derivative liability at fair value with changes in fair value periodically flowing through the income statement.)

3. Often, such instruments are erroneously valued using the Black Scholes formula. The Black Scholes formula is not designed to accurately value the embedded features of the derivative, such as down-round protection or performance provisions etc. More appropriate valuation methods would be a lattice model or a Monte Carlo simulation.

The Black Scholes model is known as a “close form” model, providing a deterministic outcome for a limited number of inputs. All inputs are observable, explaining the popularity that the Black Scholes model enjoys with the audit community. It is relatively easy to implement, in turn explaining its popularity with financial statement preparers. However, the Black Scholes model is limited to valuing “plain vanilla” options or warrants: options with no additional features. There are closed-form solutions for some of the more “exotic” options, such as barrier options or Asian options, but the features embedded in warrants seldom map to any of these.

A lattice model or Monte Carlo simulation by itself does not necessarily value these embedded features. Rather, these “open form” models allow the user to insert conditions and varying assumptions depending on stock price movements or other, additional inputs. They will need to be tailored to the specific embedded features of the derivative, and hence are more complex to set up. Most issuers shy away from implementing these models in favor of valuation firms with specialized expertise.

The Brenner Group regularly values companies with complex capital structures, including multiple levels of preferred shares, convertible debt, and warrants. We have seen a considerable increase in the need to provide support for the valuation of warrants and embedded features for ASC 815, especially after the latest guidance of EITF 07-5, and more specifically the stated preference of the SEC for issuers to use the proper valuation method to value complex features.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Original post permalink: http://banner.thebrennergroup.com/2011/04/25/when-black-scholes-falls-short/

A search for “cloud computing bubble” on Google returns an amazing 1,350,000 results, leaving our other contenders in the dust. The Google News search returns an increase to 83 results in 2010 from 31 in 2009. Cloud computing now may be more of a pervasive paradigm shift in IT infrastructure than a subsector like social gaming, and a multitude of companies are involved, or like to be thought of as being involved, in delivering a cloud computing solution. In that respect, cloud computing may be more about bubbly IT marketers rallying behind a common term to increase sales than a genuine business sector bubble.

In Gartner’s hype cycle of August 2010, Cloud Computing and Cloud/Web Platforms just surpassed the “peak of inflated expectations” and are slated for the deep dive into the “trough of disillusionment”. With an expected time to mainstream adoption of 2 to 5 years, such trough could of course be crossed relatively quickly.

Valuations for companies with some ties to anything cloud are still (or again) very substantial. VMWare is trading at a healthy 14 times revenue, Citrix is at 7 times revenue.

This leaves social gaming company valuations looking rather tame.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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A search for “social gaming bubble” on Google returns a whopping 266,000 results. Move over, cleantech! The search in the news section shows an increase from 22 hits in 2009 to 87 in 2010. Getting closer.

The social gaming industry has seen some inspiring transactions: Disney bought Playdom for more than $750 million, Electronic Arts bought Playfish for $400 million, and Google bought Slide for $182 million. Zynga gobbles up one game company after the other, making use of its war chest of more than half a billion dollars that it raised from online media stalwarts like Google, Softbank, and Digital Sky Technology.

Usage numbers are certainly impressive. According to market research company The NPD Group, 20 percent of the US population ages 6 and older reports having played a game on a social network in the past three months. That equates to 56.8 million US consumers. And anything that 20 percent of the US population does, must have some value. About 35% of social network gamers are new to gaming, and at last the interactive entertainment industry seems to have reached the elusive female audience: the majority of social gamers are indeed female.

Is Zynga, at an estimated market value of over $5 billion, a tad frothy? Maybe; but for a three year old company with 320 million registered users and estimated revenues above $500 million, such a growth rate has to account for something.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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So here goes our list of contenders for 2011 bubbles:

Cleantech

A search for “cleantech bubble” on Google returns 87,300 results. Not bad for an aspiring bubble. A search in Google News returns 74 results, up from 26 results for 2009. A Google search may not be scientific evidence of a bubble, but it can serve as a helpful proxy in our hunt for bubbles. The Cleantech Group researched that Q3 2010 venture investment in cleantech was down to $1.53 billion; 30 percent less than the previous quarter, and 11 percent less than the same period a year ago. Investments for the first three quarters in 2010 were still slightly ahead of the same period in 2009, thanks to a strong first half of 2010. Public markets are still somewhat supportive of anything green; Li-Ion Battery maker A123 systems, which went public in 2009 may be down from its high of $25.77, but even around $9.50 it is trading at about 10 times trailing revenue. Electric car maker Tesla trades at over 25 times trailing revenue, which leaves ample room for future revenues to catch up with the current valuation.

In general, it seems that the public market has not yet caught up to the more modest outlook of venture investors.

For a more bullish view on cleantech, Claremont Creek’s Nat Goldhaber looks at a rebounding IPO market to stoke the public interest in all things green in 2011.

Of course timing is everything in bubble land: one man’s short term investment gain is another’s man’s loss when the bubble pops: And, as the example of the Li-Ion battery market shows, those bubbles may take a while to pop: strategy consulting firm Roland Berger expects the shakeout in the Li-Ion battery market to decimate the number of companies from around 60 to 6. But consolidation is not expected to start until 2014. That leaves plenty of time for bets before the bubble pops!

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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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.

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



A recent survey of the professional services landscape in Silicon Valley yielded some unique insights into the top names in professional services among VCs and CEOs of VC backed companies. The survey, completed and published by the Silicon Valley Research Group in San Jose and Seattle, was designed to identify trends and the leading brands across six professional services categories in Silicon Valley.

1. Accounting Firms

2. Law Firms

3. Interim CFO & Controller Firms

4. Valuation Firms

5. Banks

6. Venture Lending Firms

The top two most mentioned names in each category are listed below.

Accounting Firms  →           Deloitte Touche and PricewaterhouseCoopers

Law Firms   →            Cooley and Fenwick & West

Interim CFO & Controller Firms   →           The Brenner Group and Ravix

Valuation Firms   →           The Brenner Group and SVB Analytics

Banks   →           SVB and Comerica

Venture Lending Firms   →           Western Technology Investments and TriplePoint Capital

For more information or for the full report, contact Shawn Fisher (shawnf@siliconvalleyrg.com ) for details.

J. Weston (Wes) Rose is Senior Vice president of The Brenner Group, one of Silicon Valley’s premier professional services firms. Wes has enjoyed an extensive career as a C-level operating executive with multiple venture capital backed technology companies and now runs the firm’s interim management and restructuring practices.

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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.

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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/