Four Common Questions About Financial Projections for 409A Valuations

January 20, 2009 at 10:43 pm

An essential ingredient of sound and accurate 409A valuations is a complete set of financial projections. 409A clients often ask what that means and The Brenner Group valuation Vice President Bill Denebeim provides answers to four common questions about solid financial projections.

What financial projections are required for 409A / 123R valuations? Particularly for very early stage companies, a “full set” of projections may not be readily available.

While the valuation analyst can work around gaps in the data, the thing to remember is these valuations are for compliance purposes. If results are higher than what might otherwise be supportable, there is little compliance risk. If the results are too low, your auditors and the IRS (ultimately), will not be satisfied. A full set of projections are key to getting the valuation result just right. Otherwise, the analyst will make “safe” assumptions designed to minimize the risk of a noncompliant result.

What constitutes a “full set” of projections?

In basic terms, a “full set” would consist of projected Income Statements, Balance Sheets, and Cash Flow Statements for a three year period (or longer). If the company expects to require additional capital (in the form of debt or equity raises) then this should be reflected. If the company expects high rates of growth (typically the case for early stage companies) then it is helpful if the projections are developed on a quarterly basis.

Projections are driven by their assumptions. If the assumptions are reasonable then the projections will be reasonable. Projections can be regarded as evidence of the current stage of development of the company, the current state of management’s understanding and assumptions about market and economic conditions, and the current goals and strategies of the business.

A full set of projections enables the analyst to perform the technical (quantitative) elements of the valuation. An income statement provides estimates of future revenue and operating profit which can be compared to other companies (public companies). The income statement together with the balance sheet and cash flow statement enable the analyst to build a discounted cash flow (DCF) model of the company which incorporates capital expenditures and working capital requirements. Furthermore, the analyst can look at the assumptions underlying the model in context and assess the degree of reliability of the quantitative results.

What if a “full set” is not reasonably available?

Some early stage companies do not have the time, money, or knowledge base required to develop a full financial model. Particularly in cases where a company is focused on technical development, management (and its VC investors) may believe the technology will ultimately address a large market opportunity but details such as product design, marketing strategies, and business development timelines may not be fully determined as of the valuation date. In some cases the analyst as part of the valuation study can make assumptions required to complete the quantitative modeling.

However, one great way to get off the ground with developing a model is to perform some benchmarking analysis. One way to do this is to select at least one public company that can act as a model. The best candidate would be a company in the same industry segment (with similarities in terms of technology, product offerings, distribution strategies, etc.) that went public in the last five years and that has performed well.

Obtain from the SEC’s website the company’s “424B” disclosure statement. This document is effectively a completed registration statement for the company’s IPO. It will contain up to five years of historical financial results for the company prior to the IPO. If you really dig into it, you can often find details about the preferred equity rounds used to finance the company. You can also find the common stock values (used to support stock option grants) that were acceptable to the SEC in the pre-IPO period. There is a lot of other information as well.

Of course the company being evaluated will be different in many ways from the selected company. But you can begin to ask yourself whether you reasonably expect revenues to grow at a faster or slower rate. You can estimate whether the cost structure might be higher or lower as a percentage of revenue, whether the balance sheet items such (accounts receivables and payables, inventories and fixed assets) may be higher or lower proportionately (or relative to activity ratios such as “days sales outstanding”). You can also use the company as a valuation benchmark, by analyzing its value at IPO relative to its trailing (and forward) revenues and other financial metrics, as well as market capitalization since the IPO.

Markets are dynamic and values can change rapidly, so care must be taken as you benchmark and interpret results. The company’s financial history can be used as a starting point for developing the set of assumptions necessary to build a full set of financial projections.

What if the company is not on the path to an IPO or has a very substantial likelihood of stalling out or failure?

Most early stage technology companies do not proceed to an IPO. The potential rewards may be high, but the risks are also very high: many stall, some fail. Others grow to a sufficient stage of development that they can be sold to larger firms. The current IPO market is adverse and may remain so for some length of time.

Generally speaking, the valuation analyst has methods for taking into account the risks and potential financial results of alternative outcomes. However, if the company does not appear to be on a path to an IPO or sale on highly favorable terms, then it is appropriate for management to develop the projections to reflect the most likely set of outcomes.

Furthermore, management can develop the projections to reflect changes in strategy and outlook. One implication is that often there is a tradeoff between the pace of growth and the amount of capital required to fund the business. A full financial model can be tool for understanding these (and other) tradeoffs.

The key criterion for the projections is that they should reflect your actual goals and expectations for the business as they were in effect as of the value date. Particularly in cases where there have been problems or set-backs and the growth of the business has been delayed, the fact that the company has developed revised projections represents an important piece of evidence for the valuation study.

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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