Monday, July 26, 2010

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.

Friday, July 16, 2010

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.

Thursday, July 1, 2010

Valuation trends and Royalty Rates in Biotechnology and Pharmaceutical deals

The Licensing Executive Society of USA and Canada (, 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.