409A Valuations in Turbulent Times – Part I
Turbulence in economic and industry conditions can have a significant impact on the result of a 409A valuation. This series of discussions describes some of the key elements where economic and market data play a role in the analysis. 409A valuations can be divided into two phases. In the first phase, an estimate of the total value of the company (enterprise value) is developed. In the second phase, the value is allocated to each class of equity. This dialogue addresses the impact of economic turbulence on the first part – the development of the enterprise value.
Valuations prepared to support stock option grants must comply with IRC Section 409A tax requirements and, if the company is subject to GAAP accounting, fair value rules found in ASC 718 (formerly SFAS 123R). These rules require the analyst to consider economic and industry conditions, as well as business fundamentals in the development of an estimate of value. Turbulence in economic and industry conditions must be considered as part of these analyses.
409A includes analysis of comparable companies
Often 409A valuations include a comparative analysis to the values observed for other companies in the relevant industry. Most management teams understand that valuation multiples related to revenue, earnings before interest, taxes, depreciation, and amortization (“EBITDA”) or other financial measures can fluctuate. They can fluctuate as stock market prices fluctuate. They can also fluctuate as industry analysts change their estimates of future growth and profitability of specific companies and industry segments.
During periods of economic turmoil, the results for a specific guideline company may change substantially due to specific issues (such as the loss/gain of a major customer) which may not be relevant to the company being valued, or others in the peer group. In these situations, the analyst must consider facts and circumstances of each selected guideline company to make sure adverse conditions at one company do not disproportionately impact the results of the study.
Valuation is influenced by market conditions
409A valuations also often include an estimate of value derived from projected future cash flows or earnings. Market conditions can influence these forecasts as well. These analyses apply a capitalization rate to projected financial results; the capitalization rate reflects estimates of the cost of debt and equity capital. These estimates of the costs of debt and equity capital are derived from prevailing interest rates and stock “beta” statistics, both of which are subject to fluctuation.
Beta measures the degree to which the change in the price of a security is correlated to changes in the equity market prices overall. A beta coefficient of 1.00 implies that a company’s return varies directly with the overall market. A beta of less than 1.00 implies the stock price tends to change to a lesser degree than the market, and a beta greater than 1.00 implies a stock price tends to change to a greater degree than the stock market.
Macro-economic and industry conditions are also reflected in the analysis. Generally, management includes in its financial projections demand estimates for the company’s products and services based on its assessment of the overall strength of the economy and demand for the goods and services in its specific industry, as well as the relative strengths and weaknesses of its offerings as compared to its competitors.
Valuations can be heavily influenced by external factors
Valuations for 409A compliance require consideration of factors internal to the company as well as external, such as market, industry, and general economic conditions. Turmoil in these external factors can be reflected in a number of assumptions in the valuation, including the comparative analysis of the subject company relative to its set of guideline companies, and economic data used to estimate the cost of equity and the cost of debt.
Far from being a theoretical exercise, external factors can significantly impact the value investors may place on an industry segment as well as the subject company itself. Under current volatile conditions, the impact on valuation results can be significant.
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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