Is Enterprise Value per employee a good yardstick for valuation?

I wanted to fit a distribution to the EV per employee metric I took from tens of 409A valuation data points. I constructed an excel chart using the "frequency" function to count the EV per employee metric as a histogram and then observed the shape and size of the histogram.

While there is some right handed tail because of skewed distributions due to biotechnology companies and some extraordinarily valued companies, I find that most valuations lie between $600K and $1.2MM per Full Time Equivalent (FTE). I call it FTE because these companies have employees all over the world under differing wages. The mean seems to be around the $1MM per employee mark. Since the shape of the distribution is substantially NORMAL, this arithmetic mean or average has a significant meaning. And as per normal distribution rules, 67% of data points seem to lie within 2Sigma from the average value, pointing out that EV per employee maybe normally distributed in the VC world. Remember these valuations are across both non-revenue and substantial revenue generating venture-financed, closely-held companies. I was talking to a VC partner one day and he mentioned that a $1MM valuation per engineering employee is a reasonable assumption. This chart seems to be bear witness to that empirical rule. I wonder if the VCs rely more on such empirical rules as a yardstick than do a cash flow analysis (which is admittedly difficult to do for a fledgling business or idea).
While there are empirical rules, it may also be that the valuation range of $600K to $1.2MM per employee may be the most valid range for small, privately held technology companies. At least, a significant sampling of 409A valuations seem to indicate this.

An analysis of 409A valuation data points

I took a sample of various valuation data points I obtained during the 409A valuation and charted it out. I believe the chart gives us some interesting conclusions.

The X-Axis in this picture is the AICPA Operational Development Level (the greater the operation level, the more mature the company is) and the Y-Axis is the Post-Money Valuation (PMV) Per Employee that a company got during its financing rounds. The PMV is just the pre-money valuation determined by the venture capitalist (VC) added to the cash infused by the VC. The analysis is interesting. The lines that connect the data points themselves are meaningless. They are just there to show where the data points lie - the bands are made clear this way. We can readily infer from the picture that most of the data points lie in the $200K to $1.5MM band. Then we have a select few that lie within the $2.8MM to $3.5MM band. And finally, we have the elevated band where a select few lie within the $4.7MM and $5.7MM band. From analysis, we know that the top most band essentially reflects biotechnology companies in our portfolio. Given the large capital needs required by biotech start-ups, we'll exclude this band. The remaining bands clearly show that there is a clear gap between two distinct bands. If you are a company that has a stellar team and a solid growth, you do get clear of the pack and command some great valuations. On the other hand if your growth is mediocre, you are stuck in a narrow valuation band. Note that the greater band's average is almost 4 times the average of the lower band. This is typically the case in the public markets as well. A company with a strong market share and a stellar team trades as much as 4 times the lower valuation multiple company. While some of the results maybe obvious, it was important for us to analyze how companies break out in the private market place. I believe we have a statistically significant amount of data points in there to draw some reasonable conclusions.

Ok, we have the search engine and the iPAD. Now what?

After looking at the issues facing our country in the last 2 years, one thing has become clear to me: technology has not been able to solve things that matter the most. The two things Americans spend most of their money are housing costs and healthcare. And the two areas that technology has been least helpful are in these areas. Technology has not helped bring about a rational housing market, discover fair market interest rates, or evolve a market place where houses are bought or sold in a fairer way. This goes for health care as well. While we have excellent mobile devices with entertaining content, we are struggling to create efficient housing and health care markets or education markets. More people seem to be able to gain access to iPAD and Android phones than decent housing, education and quality health care. Drawing from Einstein's PhD thesis on Random Motion of particles (Brownian Motion), particles travel in the path of least resistance. People do the same thing as well. They adopt and subscribe to the path of least resistance. Right now, the value in an iPAD is fair, efficient and easily accessible (the path of least resistance) than the value of owning a house or getting healthcare or electing the Congress or investing in the stock market (the trading volumes have plunged). When people face resistance in a path, they tend to drop that path. So, owning a house, obtaining health care or electing the right people are going to go out of fashion, while buying video games, music, iPAD are going to catch on - simply because it is so much more easier to do so. The younger generation has certainly moved away from owning a house (they all prefer renting), buying health care (they prefer community clinics) and not participating in electoral process (they dont see the right candidates) and have instead resorted to buying mobile devices of all sorts and making friends on online social network (resistance faced in the actual world??). Note how Apple's stock or FaceBook's private stock has shot up in a time of volatile housing and healthcare markets. Everyone knows that an iPAD cannot give you better health care, cook better food for you - yet we choose iPhones and iPADs over health insurance or buying quality food. It is not the fault of the consumer that we've become so, but the amazingly resistant paths that powers-that-be have created to owning houses or investing in healthcare or working the stock market. Maybe I should have an XBOX, PS3, WII, iPAD, iPhone, plenty of friends in the online world and a large monthly broadband bill. Why bother about health insurance or food or a roof over the head? They dont come handy in the online world that I may want to live in.

Why Intellectual Property needs to be periodically valued?

There has a been a research study which says that S&P 500 derives 67% of its value from Intellectual Property (IP) or Intangible assets. Think about it for a minute. The largest export from America today is IP. In a deteriorating business climate, what sets you apart from others are sustainable competitive advantages such as your workforce, patents, trade marks, copyrights, goodwill, client lists, trade secrets and other protected and escrowed intellectual properties. You owe it to yourself to start building and sustaining companies that hold IP value. Today, most of the manufacturing and even a large part of R&D processes can be completed outside the US. This means that cutting edge IP is probably the only thing that will fetch valuation multiples in the 7 to 10 times revenue range. VISA, WalMart, Google all command a high P/S multiple because they all hold vast amounts of IP in the form of technology that really sustains their businesses for tens of years. Any company that does not hold IP and in turn does not enjoy a sustainable competitive advantage tends to see lower P/S multiples. So, what do we at Accuserve see when we value intellectual property? Though there are guidelines out there, many fall short of the changing headwinds in the nature and protection of IP. Two major things contribute to how much an IP is worth: the business value of the IP and how much the IP is legally protectible/protected. The business value of the IP, in turn, depends on factors such as the stage of development, novelty of use, difficulty of reproduction, size of the target market, barriers to entry, government support, volatility of the cash flows expected to be generated by the IP, prevailing royalty rates for similar IP, geographic range of application, and ease of licensing. Legal protection examines things such as the time period of exclusion, litigation aggression, escrow facility, and freedom to operate. While financial analysis contributes to developing cash flows associated with the IP, a through understanding of the qualitative factors is required to create factor models that capture qualitative inputs. We are experts in doing that. Given the importance that IP holds in today's environment, it is important to get an IP valuation that is highly supportable and fetches the optimal price.

Why participating preferences maybe absurd and how 409A valuations can consider this absurdity?

Imagine a term sheet where your pre-money valuation is $25million and you raised $5 million. The post money valuation therefore is $30 million and the VCs share of the company is 5/30 or 16.7%. Now, the liquidation preference (typically at 1X the investment dollars or issue price) would be $5 million and let us say the VC wants another 1X in participating preference. One of the interesting things to note is that the $30 million valuation is almost 6 times the liquidation preference ($5MM) and 3 times the participating preference ($10MM) thresholds. When analyzing the waterfall model, it can be shown that the full per share issue price of the VCs stock is reached when the valuation equals or just crosses the liquidation preference amount. Anything beyond this is a value that accrues to the preferred share price until the participating cap is reached at $10 million valuation. Given that the valuation right on the day of investment is $30 million, the VCs would have made money on their stock on the day of investment, and then some, as the valuation would have crossed even the preferred participating threshold. And, if the issue price is set in a certain way that the VCs would find it in their interests to convert to common stock, then even more money would accrue to the per share price of the VCs, right on the day of investment. Note that this money is only on paper and no worthwhile progress toward creating or meeting milestones has been made by the target company. The valuation conundrum leads to the creation of artificial wealth. Whew, talk about magic money.
On the other hand if the valuation was just restricted to the liquidation or participating preference caps, then the VCs would end up owning all the shares in the company - a non-viable proposition as well.
This is one of the reasons we do not take VCs post money valuation as the sole indicator in 409A valuations. We even go as far as to term this "investment value" - a notation that can be given less weight under 409A valuations, or some times, depending upon the investment conditions, completely ignored.

409A valuation and mark-to-market reconciliation

409A valuation, as we know by now, is supposed to be a legally sound valuation, though some offshore companies would never get this concept due to the poor legal environments in their own countries. But what about the FAS 156/157 US GAAP mark-to-market accounting that venture capitalists and other institutional investors are supposed to maintain? Currently, the 409A valuation study and US GAAP mark-to-market valuation study are two different projects. We are not sure how this can be the case. In a 409A valuation, not only is the minority common stock valued, but the pre-discount(if any discounts are allowed at all for institutional stock) values of institutional investor held preferred stock is also valued. Shouldn't this preferred stock value reconcile with the mark-to-market accounting of preferred stocks in a portfolio held by VCs? I believe the jury is out on this one and there is no clear cut direction from the FASB or the audit firms. One line of thinking is that companies are private for a reason, and should not be subject to such reconciliations. But if the fair market value definitions of both 409A and US GAAP mark-to-market accounting are the same, I am unable to see why there should be two different valuations. 409A valuations, for the most part, mark down the valuation offered by VC firms during a term sheet financing, as a VC financing valuation cannot be fully supported as the only method of valuation. Therefore, there is a conflict right away in that VCs have to mark down their portfolio values.I see this as an area of conflict in the future and currently we are unable to determine which way the tide will turn.

Valuation trends and Royalty Rates in Biotechnology and Pharmaceutical deals

The Licensing Executive Society of USA and Canada (http://www.lesusacanada.org/MainNav/Resources/biopharmrates.aspx), reports in their 2008 Royalty rate survey (a total of 230 deal responses were submitted, out of which 155 completed deals were analyzed) that:

• Small Molecule compounds were included in close to 50% of deals 
• Anti-cancer compounds/drugs comprised almost 33% of all deals reported and analyzed
• 88% of the deals were exclusive
• 80% of the deals required an upfront payment, with an average upfront premium for pre-clinical deals hovering at $600,000 and for pre proof of concept at about $900,000
• 90% of deals included U.S. rights; 70% were worldwide
• 57% of products subject to the licensing agreement have estimated peak sales of less than $100 million.
• 54% of the deals included Fixed Royalty, while a sizable 33% included tiered royalty rates, with the popular tiering being 3 tiers
• Average fixed royalty rates for pre-clinical products was 4.3%; average for pre -proof of concept was  4.6%; average for post-proof of concept was 11.6%
• Average royalty rates for biological products slightly higher than small molecules
• The range of tiered royalty rates (proof of concept is typically between Phases II and III of clinical trials) were: 
• Pre-Clinical: 5-8%; 
• pre-proof of concept: 7-10%;
• post-proof of concept: 14-18%

Now comes, the interesting part of the survey: about valuation. Astonishingly enough, NPV or rNPV valuation technique was used only in 19% of the deals. Among that small percent, Pharma deals had the highest share of NPV calculations at 36%. Most of the NPV calculations happened when the compounds/drugs involved were dermatological or gastrointestinal. Our belief is that since the market data and industry size are well established for these industries, it perhaps is easier to use NPV calculations. Only 30% of the anti-cancer compounds, the largest among the deals analyzed, were subject to an NPV analysis. In academic deals, use of NPV analysis was almost absent, despite some of the licensing academic institutions having the best among the financial engineering departments.

Valuation methods and public markets debacle: Are there lessons for private company valuations?

While examining a number of valuation models and arguments by audit personnel, we found that many were overly focused on the use of sophisticated valuation tools rather than on the validity of the underlying data. The idiom "Garbage In, Garbage Out" holds true here. Like we witnessed in the Collateralized Debt Obligations (CDO) debacle on Wall Street, sophisticated valuation models with the wrong data in them or inadequate stress testing are bound to fail. Random scenario based modeling are cost effective and human judgment based discrete scenario methods are more expensive. But, should we rely on the cost-effective, random scenario calculators and ignore the human judgment-based discrete scenario computations? Rather not! The economic debacle has clearly spoken against using black box type methods.
Valuation methods and theories exist that completely define how to value companies and even privately held companies. There is really no need to keep devising newer valuation techniques or building in sophisticated volatility or stochastic models. The focus should be rather on what kinds of data go in them. Are the cash flows reliable? Are the timing of the cash flows appropriate? Are the margin calculations reasonable? Are the 3 or 5 year compounded growth rates of revenues and earnings reasonable. Is the revenue per employee or operating expense per employee reasonable for a company of a particular size, industry structure, competitive environment and financing options? Is the free cash flow to sales ratio broadly in line with industry peers? At Accuserve, we built factor models that adequately capture inputs from both qualitative and quantitative data sources, to assess the risk profile of a privately held company. This profile is then translated into a quantitative discount rate using proprietary models. Our contention is that using straight-up, vanilla Capital Asset Pricing Model or the Ibbotson Model to measure private company discount rates ar fraught with risks, and one that should not be encouraged by audit firms and especially companies that get their done overseas, who invariably employ such short cuts, to save costs and time, and are not true to the American philosophy of investigative conclusions of opinions. But should we let such philosophies creep into our mindsets here? While the private valuations are smaller and perhaps do not have the domino effect that a failed public venture may have ("too big to fail" may not apply to private companies), it is important to learn lessons from the public markets valuation debacle and apply them to private-held companies' valuations as well. That would mean we do NOT need stochastic, black box type options based models that can value thousands of companies within 1 minute, but models that force the exercise of human judgment and force the explanation of the specific economic, industry, company and customer situations that stock holders in private companies face. Valuation models should focus on verification of underlying data and applications for tests of reasonableness, more than the tools themselves. In other words, evidentiary standards on the lines of a judicial inquiry are perhaps more appropriate.
The mistakes that public companies did by outsourcing research overseas and resorting to black box models that led to failures of companies such as Long Term Capital Management (LTCM), on whose Board sat Nobel prize winning economists, says a lot about the lack of exercising subjective judgments. This country cannot afford efficiencies that come with super efficient valuation models that are totally driven by computer models and offshore analysts.
Valuation exercises that make the appraiser, the company's management and employees introspect about the nature of the businesses they are in, the future prospects, whether deployment of capital will yield more than a risk free rate creating more wealth for shareholders, is a proper mix of debt and equity used to achieve the optimal cost of capital, and whether their financial performance is in line or superior to their peers or industry are perhaps the most useful. Valuations that simply are done for the sake of regulations or done such that the cost of doing it is the lowest, with accuracy and relevancy thrown to the winds, have no meaning and should be avoided. This country cannot afford wasteful economic activities anymore, and valuation is certainly an economic activity we can ill-afford to become meaningless.
Finally, IRC 409A valuations impose a set of valuation standards, if adhered to, will surely help companies introspect and gain insights into the beneficial factors I detailed at the beginning of this paragraph. These valuations need to be used as a strategic management exercise. By treating these valuations as something purely regulatory and farming them to the lowest cost destinations perhaps makes these valuation meaningless, a cost that the country can ill-afford.

Evidentiary requirement and 409A valuation

Several clients ask us questions about what types of information is collected and why. You see, 409A valuations have got more to do with substantiation and evidence and less to do with valuation techniques and number crunching. One of the things we have noticed, especially, in valuation work from overseas is use of data sources, enumeration and explanation of data, and calculation methods that dont quite fit in with US Tax Court lingo or evidentiary standards. We collect information that is more appropriate to pass the evidentiary standards set out in usual IRS court cases and US GAAP standards. This also makes the audit work a breeze as most information they are looking for is set in in the manual. While working with one client, they mentioned that a company in India charges less for valuations and then when we inquired as to what they normally ask and process, the client mentioned that they use a single approach to arrive at results for all firms. Use of a single approach goes against the well established US evidentiary standard that all available approaches have to be weighed, before one or more approaches can be discarded. This "discarding" process has to be shown through calculations and comments. Cutting work short and then paying less for that defeats the evidentiary standards set out in the US. While the cost, income and market approaches are the usual methods to evaluate a firm or its assets' valuation, use of these methods have to be relevant and appropriate to how the "most advantageous transactions" market currently uses them. The valuations have to be created to reflect as if the buy or sale transaction occurred in the most advantageous market. Another thing to note that is the fact that, in the US we have something called "investment value", that widely differs from fair market value. Investment value cannot be used for 409A valuations. In reviewing valuations from overseas, we find that specific notations to which valuations are "investment" and which are "fair market", are totally missing. We are not sure how these valuations even pass US audit requirements as many of the valuations are shallow and will not stand scrutiny here, should the IRS were to scrutinize them in  the future. While many of these foreign firms are presenting a quick, short valuation report, companies beware that they may not meet US evidentiary standards. We do understand the analytical strengths and cost advantages associated with doing overseas work. But cutting prices and sacrificing evidentiary standards is something we cannot advocate to any of our clients.

Website value calculators are not appropriate for all website valuations!

There has been a mushrooming of website valuation calculators that purportedly calculate the value of websites. Most algorithms claim that they use a host of freely available information over the web such as back links, page views, rankings and other similar information to calculate the value of your website. Then they also also claim that they "estimate" how much advertising dollars the website will generate on all of its pages and use that as the revenue measure. The issue with such a calculation is that the calculators are applicable only for websites that has advertising as its primary source of revenues. Websites that do not use ads as primary sources of revenues but rather to attract work or as an advertising in itself, which is what most websites are, cannot be valued this way. Over reliance on the use of advertising as the revenue source misleads people into thinking that their websites are valuable when they clearly are not. This also spawns numerous advertising only websites and contributes to plenty of junk redirects out in the Google search space. Upon a deeper look at the "automatic placements" by Google in our AdWords account, we found that 70% of the websites are junk websites solely created for the purpose of advertising redirects. What purpose do these websites serve? This is a main reason why we get a lot of what we call junk clicks. The reason many of these redirecting websites exist is because they are under the false impression that their websites or businesses are valuable based on a stream of Google AdSense dollars. Surely, traffic redirectors cannot be worth as much as traffic from quality websites. But I do not see any differences in CPC between clicks from redirectors and from quality websites. Of course, a click from a well vetted, reputable website is worth several times more than a click from a traffic redirector website that is setup solely for the purpose of capitalizing on the ad commission spread. I am not sure if AdWords can set up algorithms that reward authenticated, respected websites more than the others. Only very discerning customers visit our website and therefore our traffic is low but at the same time, the customers who come on our website are perhaps serious customers and if they click on an ad on our website, the probability of conversion is several times higher than on a redirector website. So, is the value of our website low? That's what the website calculators think and therein lies the problem with the ad model. We need to be paid out a higher cost per click than a redirector website. We qualify prospects better, yet perhaps we do not get rewarded for that. I hope Google introduces a system where quality information is rewarded much more than opportunistic, junk traffic.

Too small to cope with 409A regulations? Try Restricted Stock!

One of the things about 409A regulations is that it imposes a valuation requirement on you, which could be expensive depending on the service provider. Not every service provider operates efficiently and only a few like us are able to provide the highest quality at affordable rates. It took a lot of trial and error work, technology utilization and template work to get to this business proposition. If you are a very small founder and your head swims over how to create paperwork for 409A compliance, I recommend you use restricted stock for your employees. Restricted stock is outside 409A requirements and you dont have to get a valuation done to determine the fair market value of the underlying stock at the time of the grant. While restricted stock units are attractive, if you include clauses such as the right to call back the stock, then the position maybe treated akin to an option and may end up falling under 409A. So, make sure you issue a plain vanilla restricted stock. You also attract taxes only when you actually book a capital gain on the stock rather than a possible tax payment right at the time of grant as in an option. There are advantages to issuing an option such as the inexpensive costs that companies have to bear and significant upside, should the stock price go up. But if the stock price went down, you may not have any stock at all, unlike in a restricted stock scenario where your stock is worth something unless it goes to zero. This means that it is important to issue stock options at very early stages of a company's development but the hitch is that it requires significantly more paperwork than restricted stock. Hybrid solutions are possible. Please contact us to learn more.

Are some service providers violating the Independent Appraisal Presumption that is a MUST for a 409A valuation?

When we analyzed some of the service providers out there for 409A valuation services, we have come across some companies that provide 409A valuation services possibly in violation of the independent appraisal presumption. These companies provide other services such as banking, receivables collection, IPO advisory, CFO rental services and similar such services for a fee to privately held companies, yet at the same time provide 409A valuation services. The Independent Appraisal presumption requires the appraiser to have an arms length relationship with the clients and not be affiliated under other business activities. It is important for companies to insist on laying out in the certification that the appraiser works under the "Independent Appraisal" presumption, so as not to have the entire report invalidated by the IRS during an audit.

Does Google click for you? Are there link frauds, bid frauds and click frauds?

I have learnt quite a bit from using Google Adwords for my advertising campaign. I have been able to tweak key words  and write blogs that have pushed Accuserve to the #1 result when the keywords "409A valuation", the most relevant keywords for our business, are used in the search engines. My blog results also show up as #1 for that keyword. But here's the problem: Google seems to want me to increase my ad budget to capture all clicks. But the clicks I currently have do not translate into much sales and therefore I have concluded that Google advertising works only for direct business-to-consumer type businesses. Since most business decision makers would go beyond just ads to learn about a company, I believe that for product purchases that require credible decision making, Google Ads may not be that relevant. In my business, if the first 20 clicks do not get me business, I wonder if the next 20 would. Therefore, its not a numbers game for me and increasing the budget to get more clicks. Increasingly, more clicks are being provided by ad placements in targeted websites rather than generic search engine searches. I wonder if the buyers are making their decisions more through credible gate keeping websites than just looking at Google ads directly. In a way this is good for our business as we maintain our credibility by attracting buyers that visit specific gatekeeper websites. The cool thing is that AdWords provides a nice way to target these gatekeeper websites. Managing your brand and reputation is key and it is important where and how your ads are clicked. This has been a key takeaway for us. My advice to businesses that provide services to other business (B2B) is to take a hard look at data. If the first 20 clicks on ads displayed alongside search engines dont get you business, the next 20 most certainly wont. While Google prominently recommends increasing your ad budget, I believe that B2B service providers may not necessarily benefit from that. The right thing, perhaps, to do is build your brand through insightful knowledge conveyed through blogs and making others link more to your site, leading to displaying of your site at the top of the search results, because that's how Google algorithm works. But it appears that the system can still be beat. What if you pay to get a lot of people to link to your site or aggressively promote your links to be embedded within others' contents for a generous payment. Garbage in, Garbage out at action here. While you may get traffic to your site, you'd probably wont get much business out of this junk traffic.
It becomes important to spend your budget in a way that minimizes junk traffic or traffic that dilutes your brand - easier said than done in the way AdWords is setup right now. Many of our keywords' bid prices are going through the roof and I just dont see that much competition in our industry, given the specialized nature of our services. This leads me to question if there are bid frauds as well, aimless junk traffic bidding up the keywords, in return for some payment. Right now, the advertisers seem to be not complaining much, perhaps, because even with junk traffic there are some business returns. But, are your returns from selling your product/service or by becoming part of this junk ecosystem where you participate as well, making Google a commission based enterprise? Some points to ponder, dont you think? Do we want Google to be a positive economic value adder or just a market place where we all keep paying each other to keep generating ad frauds? This reminds me of Wall Street and how artificial returns were created.

The "Take Notice" effect on revenue modeling for start-ups

After completing more than 400 valuation reports including 409A valuations, we have obtained certain heuristic knowledge that we can share for the benefit of the start-up community. In this blog, I want to analyze something called the "Take Notice" effect. We have reviewed business models of so many companies that have almost similar hockey stick type projection of revenues. When we review these models, one question we ask the CFOs and the founders is have you ever considered the effect of companies taking notice of you when you have just become the right size that existing companies get threatened by your business model. After Google greatly disrupted the Madison Avenue business model, most existing companies are on their toes to look out for potential business threats. And they try to mitigate this threat using a variety of tools at their disposal such as lowering prices, lobbying for biased laws, cartelization, hostile acquisitions, hiring away key employees, and increasing the cost of acquiring capital. After analyzing so many companies, we believe the take notice effect is somewhere when your company reaches the $20 million revenue stage for hi-tech companies (Biotechnology companies are different and we'll reserve that discussion for a later blog post). This is the point at which most investors want to commit to further mezzanine rounds and take the companies to a ripe 100 million+ revenues level, a level considered prudent for financial exit. So, when you reach $20 million in revenues, expect competition and a slow down in growth. We call this growth model the hockey stick dip or the heart pulse model. No doubt you will take off in a hockey stick manner but there is bound to be a dip after the stick's peak is reached and then levels out to more acceptable growth rate levels. If you look at your heart rate monitor, you can see that the wave pattern matches what I am talking about. It is important for founders to acknowledge this dip as competition intensifies and to forecast a small dip in revenues or at least a zero growth period with increased spending for some time. This is also a period of transition. Some founders are good at starting up and enjoying the hockey stick growth but not so good at managing a dip caused by the "take notice" effect. This is the time for the founders to assess if they are the right people to be leading the company at this stage.

Do start-ups have to project a growth of 150%+ to get a good valuation?

During one of our 409A valuation analysis and the subsequent sale of the company to a public company (known for bargaining fair valuation multiples), we discovered that the company had been strategically sold for a valuation multiple much higher than the MVIC to Sales or Price to Sales multiples available out there for comparable companies, even industry leaders. This high valuation multiple confirms our assertions:

1. The market for good assets is still good. The asset under question had revenues projected to grow at 35% CAGR over the next two years but become profitable only in 2011.
2. There is a dearth of good quality assets out there. Public companies are still bidding for the right assets.
3. It is important that companies work longer and harder to reach positive revenue stages and an EBITDA break even point that could be almost certainly achieved in 2 or 3 years after the sale.
4. We see a lot of start-ups projecting their 3 or 5-year compounded revenues to grow at very high rates, often running in excess of 150%. Not really necessary to do this. As we can see a 3 year 35% CAGR at a mature revenue stage gets you a good valuation. This company even during its early revenue stages projected only a 76% CAGR for 5 years. At Accuserve, we believe that credible revenue models show maturity in a company's management and leads to much better performance benchmarking, rather than reaching out for outlandish targets.

We hope start-up founders will take note of how business is actually done and how exits are achieved. We are always available to advise on such matters.

What methods are being used for biotechnology valuations?

In March 2009, Sangeeta Puran, Senior Associate, of Mayer Brown International, London, UK completed a study examining the methods used to value drug development programs. The study was conducted by interviewing individuals in the UK for a period of four months from a representative sample of twelve leading industry participants, including small biotech business development, large pharma and large biotech business development, financial analysts and venture capitalists.  Overall, according to the study, most participants tended to only use the more conventional tools of rNPV and comparables, with only a few participants (namely pharma participants) using other methodologies on a regular basis. At Accuserve, we use rNPV extensively for biotechnology valuations and have built a body of models with industry wide stats that help us better approximate drug development times and operating costs incurred in different phases of development. We also have been able to input ODTC offsets and accelerated development time frames to compare and contrast various drug development cycles. Needless to say, this experience comes over a period of time.
Turing to using comparables, during the study, one participant commented that everything was in a bit of a muddle. Another participant opined that prices are being eroded and that there are 3 key factors:
 - the public biotech/pharma market currently has a very low value
 - biotech companies are desperately running out of cash
 - everyone is saying values are slipping and values are slipping
Given this environment, we at Accuserve, strongly recommend that companies use a bidding process to license out their innovations. We believe that good quality assets will still get good prices but the ones at the bottom are probably not going to exchange hands that easily. Generally, even if we get at a fair market value, we have seen that in auction processes the bids invariably end up higher for good quality assets. This is especially true given that there are not very many Phase III projects around. The demand for technologies that can potentially migrate to Phase III is going to remain high.
According to the report: Upfront payments were the most heavily negotiated. Upfront payments typically are negotiated based on comparables. The two things for which data is extensively available out there are upfront fees and so called 'biovalue deal' value, according to the report, Accuserve also has felt the same in that we have more access to upfront payments and biovalue deal data. Needless, to say milestone payments can be inputted into the model by looking at financial statements.
Clearly, the participants were apprehensive about using comparables blindly and wanted to rely on more concrete information such as upfront payments and biovalue deal.
The other methods, in our experience, and according to the report are used in very limited fashion, except by large pharma buyers, who have an army of analysts to throw at the valuation.
In our opinion, rNPV if properly modeled out continues to be an appropriate method to arrive at a fair price for the assets. The caveat here is that in an auction type environment, prices generally tend to get higher than the fair value. 



  

Post the dot com bubble: Silicon Valley job and innovation report

The Bureau of Labor Statistics in its Regional Report dated August 2009 says "Of the 11 industries analyzed in this report, 8 experienced employment declines and 3 industries—pharmaceuticals, aerospace, and scientific research—exhibited employment growth during the 2001 to 2008 period. " The BLS report states that employment in silicon valley declined by 17% in the 2001-2008 period, while the average wages grew approximately 36% in the same time frame. In March 2000, the NASDAQ reached a peak of 5130. But by December 2000, the index had dropped more than 50% to stand below 2500. The employment rate took a big hit and Santa Clara county posted a 7.6% unemployment rate soon. By 2004, however, jobs in the hi-tech sector returned and by 2008, jobs in specific sectors such as Aerospace, Pharmaceuticals, and scientific research had added enough jobs to exceed their pre-recession employment levels. While Silicon Valley's jobs stagnated between 2001 and 2008, nationally, the jobs grew by 4%, according to the BLS report.
Despite this downturn, silicon valley continues to be the hot bed of innovation: in 2008, 11 out of the top 20 cities issuing patents in the Unites Stated were in the Silicon valley.
What about the recent recession, you ask? According to the BLS report, despite the recession that began in December 2007, Silicon Valley high-tech employment grew by 2.5% during 2008; however average wages fell by 1.5% during this period. Further, the BLS states that sample data so far and anecdotal evidence suggests that high-tech employment declined in 2009, perhaps negating the 2008's marginal employment gains. For more information visit US' Bureau of Labor statistics site (http://www.bls.gov)

IRS begins Section 409A audits?

According to a release by Jones Day (http://www.jonesday.com/newsknowledge/publicationdetail.aspx?publication=6738), the IRS has sent Information Document Requests (IDRs) to companies that fall under Section 409A. The 409A section, as we all know, was enacted in 2004 (signed into law as part of the American Jobs Creation Act of 2004 and became effective Jan. 1, 2005) but took effect for most private companies beginning 2007. It appears that in 2010, the IRS will scrutinize this section more, despite some CFO organizations calling it the worst tax and citing plenty of confusions with the code.

Due diligence in 409A valuation reports

I wanted to write this note because we are receiving projects/reports where lack of communications between appraisers and companies is leading to erroneous reports. In a 409A valuation report, the emphasis is always on due diligence and supportable data/conclusions and less on the tools to arrive at the final discounted value. It takes industry experience and an understanding of the risk factors to ask the right questions, document them and then weigh the various approaches that contribute to the final decision. Recently, a firm came to us with a report that was rejected by an audit firm. This firm had used outsourced analysts in a foreign country (visible from the way the report was written), who had not communicated properly with their clients and ended up using unjustifiable calculations. We had to redo the entire analysis and report and ask the right questions. In fact this firm does not take into account the post money valuations at all in their assessment of a firm's value, most probably because the overseas analysts probably did not know of such evidence. The irony is that this firm advertises widely on Google touting its discount pricing and use of overseas analysts. A review of their reports showed that they always used only one approach, going completely against the methods suggested in the AICPA practice guide. Further, their volatility calculations were arbitrary and lacked support. Forecast parameters were not validated against comparable peers' ratios. In one of their spreadsheets, the fair market value for common stock was pointing to the preferred stock cell. I would advise clients to exercise caution when procuring valuation services from companies that cannot defend them or cannot make available their principals for audit. If your auditor does not accept your valuation, you may end up having to get a new one done at additional cost. Today technology exists to provide affordable valuations using a fully staffed team in the US. We strongly recommend that US firms use US based appraisers for their valuation needs. Accuserve uses a fully staffed US team to provide valuation services, yet our costs are very comparable to companies that outsource them.

IRC 409A tax court cases

With some of the first court cases appearing in the 409A area (See Slater vs Commissioner of Internal Revenue at http://www.leagle.com/unsecure/page.htm?shortname=in20100111d35), it is time to assume that the IRS is auditing 409A provisions and associated valuations. It is in this background we have to note the mushrooming of firms in this area. It has come to our notice that several firms are getting the work done overseas and in fact there are foreign firms offering these services in the US. One of the main issues with working in an outsourced manner is the lack of an expert that can be relied upon as expert testimony in such cases. As we all know, the IRS imposes penalties if the tax liabilities have not been measured under a fair market value standard under the 409A regulations. Given the size of IRS penalties and the nature of add-on penalties, it is important to work with US based firms that have a good understanding of the legal systems here, an understanding of what it takes to be an expert witness and have solid relationships with audit firms. We have been concerned a bit by the outsourced model, where foreign analysts compute and calculate the valuations with no experts out here to back such values. While costs are a major factor for start-up companies in getting this work done, firms such as ours have used technology extensively to negate the cost savings arising from an outsourced model. Given that we fully back our valuations and our principals have been subject to audit processes,  we believe that we offer the best possible affordable service in this area.

Lets play the ratings game!

Now that the Goldman imbroglio threatens the forward economic movement again, it is important that we ask plenty of questions. While Goldman is being sued for acts of negligence, why arent the rating agencies being sued? 93% of sub-prime mortgage was downgraded from AAA to junk status at the beginning of the crisis, yet the agencies get to have immunity. If the rating agencies cannot be sued, why was it set up that way? There are solutions going on about how ratings agencies need to change their business model and one of the proposed models looks very much like what the FHA did with how it chose appraisers. The FHA got the lenders to use an independent business to farm out the appraisals, eliminating the bias in choosing a particular appraiser. So, the advocates of this theory now want the SEC to step in and choose one of the appraisers of these securities. One more thing: what were the bond investors like PIMCO doing? Are'nt they supposed to be doing their homework in assessing the fundamentals of their holdings? They too have an army of analysts, you know. Relying on the AAAs issued by the S&Ps of the world only got them shot. Yet, they refuse to complain about the rating agencies.
Taking this a bit further and a thing I have suspected most, are our personal credit rating agencies. I believe this system is rigged as well in favor of the banks. I have looked at some statistics dished out by the personal credit rating agencies and the numbers do not add up. Numbers such as the risk rating and the number of consumers above or below your risk rating do not conform to what we know about what is going on in the economy. Though, we pay for accessing these ratings, the model seems to be skewed in favor of the banks. So, no matter who pays, there seems to be biases built into the credit rating system.
How do you solve this? Can we build a truly efficient, competitive market that cannot be gamed? It is up to us to take control of our finances. Large institutional funds, remember, are just aggregators of your money and then unwisely invest them into so-called AAA rated sub prime securities on the advice of an investment banker, who shorts those holdings at the same time. Wake up investors and ask questions! That truly seems to be the solution to me,

When negotiating term sheets, should a founder just focus on anti-dilution clauses?

Many founders are focused on whether or not to include anti-dilution clauses. What they fail to realize is that the funding structure is more complex than just dilution. A VC can invest in a way that it may look like you are holding 50% of the company's common stock, but you may get allocated a much lesser value. For instance, if the VC negotiates a 2X liquidation preference with a full participating feature with a cumulative dividend pay out of 8% per year (and barring dividends to be paid to the common stock holders), the common stock despite having a 50% position may in reality get less than 10% of the company's value at exit. They can also add warrants that currently wont dilute common but on exercise will (it is just a delay effect - makes the founder's stake larger than it actually is). All this mean your stake has been effectively diluted through a variety of means and not just direct dilution. We use random scenarios to prove what a founder will get in different negotiating situations. There are also pay-to-play clauses which also affects common stock value. If you have anti-dilution protections in there, the VCs will simply negotiate a stricter participating preferred stock. The only way to negotiate is to go in with a game theory based model and keep plugging in VC numbers in a Monte Carlo random simulation scenario to see if the founders have a decent RoI under a random exit scenario.

I strongly advise that founders consult with experts like us to see if VC terms are fair game. We can calculate this using prevailing peer volatility considerations. If you are returning a VC more than the average return a VC expects, you are really not negotiating very well. We have reviewed so many SPAs where dilutions have been achieved through several creative terms. The VCs are good at this - they have analysts on their side. Founders need to get someone on their side as well.

We know of companies where the VCs had so many clauses that founders had to renegotiate their stakes when they realized that, in the middle of their  company's development, they wont even get 1% of the return. We had to go in and create a new preferred security class for the founders instead of the usual common stock, just to keep the RoI fair and the morale high.

Series A and Series B term sheet negotiations are critical to realize a fair RoI the founders. Fortunately, today, we have decent models to do this.

A good year for Biotechnology ETFs

AccuServe uses domestic, specialty ETFs focused on health care/biotechnology to assess how these funds performed and arrive at an overarching trend year-over-year for valuations. 1-year returns of such funds have ranged between 11.6% and 57.4% with a trading volume-weighted average of 25.8% return. Clearly, the valuations have improved significantly. The relatively highly traded (70.7% of trading volume) healthcare sector SPDR's 1-year return increased by a significant 25.43%.

Private equity/VC valuation and 409A

At Accuserve, we serve both the venture capital/private equity companies (when we mark to market their portfolios) as well as portfolio companies when they issue stock options, acquire intangible assets and so on. One of the recent observations has been as to whether only one set of valuation is required for both mark-to-market purposes for the VC/PE firms as well as the underlying common stock valuation for the portfolio companies. After all, during the minority common stock valuations for the portfolio companies, the preferred price of the VC/PE holdings is calculated as well. Currently, our observation is that not all VC/PE firms may be using the preferred price calculated during the 409A valuations for their FAS 156/157 mark-to-market purposes. Neither have we come across discussions with the accounting and audit community that such a conformity is required. Note that by virtue of following the AICPA guidelines for 409A valuations, we conform to the letter and spirit, the FASB 156/157 guidelines as well. There may be minor deviations but the fair value definitions of both 409A and FASB 156/157 are virtually identical.

Founder Stock Sale and 409A valuation

In today's tough economy, founders of small companies are figuring out a way to get more liquidity for their stocks by partially liquidating their holdings with existing investors. This could mean that founder's common stocks are being bought at the latest preferred stock prices, thereby creating implied valuations that may make the minority common stock price jump by a degree of magnitude. Founders and employees, of course, are alarmed by such big jumps in value and try to find ways to minimize the valuation and tax impacts. In recent conversations with PricewaterhouseCoopers professionals, we have come to understand certain conforming treatments that would be in line with the spirit of the 409A guidelines when valuing such scenarios and may help minimize such impacts for the founders. Contact us for a more detailed analysis of your situation and to discuss our understanding of such situations.

ETF returns and technology sector valuations

AccuServe uses domestic, specialty ETFs focused on technology to assess how these funds performed and arrive at an overarching trend year-over-year for valuations. 1-year returns of such funds, as of December 1, 2009, have ranged between -45.3% and 188.96% with a volume-weighted average of 74.36% return. Clearly, the valuations have improved significantly. The highly traded technology select sector SPDR's 1-year return increased by a large 67.44%. This increase has also translated into improved valuations for private companies.

SEC and private company valuations

Image via Wikipedia

In response to a few requests from clients on what the SEC though about how private companies should be fairly valued, I talked to an official at the SEC about this specific question. The reply was on expected lines: "use your judgment and make sure that observations are justified". Though, we at Accuserve, believed that SEC may not comment that much on private company valuations as these firms were outside their jurisdiction, we wanted to assure some of our clients who wanted to know if the valuations conformed to SEC norms. One of our question was if the SEC had any specific inputs on what approaches are better for private company valuations and, if multiple approaches were used, whether they have any observations on the weightings to be used to get at a single value. The SEC official, again, did not have a comment on any specific approaches or the weight splits to be used across the different approaches. In about 30 minutes of conversation I had with the official, one thing that stood out was the need to take into consideration all circumstances of the company in determining the proper valuation - a well established concept in private company valuations, in any case. So, we at Accuserve, are of the firm view that supportable valuations are those that can be well defended and there is no one single template to valuation.