Why Post-Money Valuation Is NOT the Same as Fair Market Value

June 15, 2009 at 11:04 am

One question we frequently get concerns the relationship between the post-money value of a company provided by a venture capitalist on an early stage financing and the fair market value or fair value of a company as estimated for 409A or 123R purposes, respectively.

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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