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.

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.

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.

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

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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.

California digitizing textbooks?

In what maybe a decent move to usher in some semblance of fiscal management of the California Budget with its gaping hole, as wide as the recently discovered Borealis Basin on Mars, Gov. Schwarzenegger is talking about introducing digitized textbooks in schools - K1-K12. By some estimates, California Government's share of the textbooks comes to around $300 million (smaller than the cost of building a B2 bomber) but large enough to warrant discussions to reduce it. It is pertinent to note that digitized textbooks have already been introduced in some schools in China and other parts of the world. One of my clients is a leading promotor of digital education services in China and the company was able to profit rapidly from the Chinese government's deregulation of the Chinese education industry. Tons of paper is saved as well, which will net the California Government a large amount of carbon credits that can be further off loaded and traded in the green exchanges. Finally, information can be updated on the fly so that students do know that the Borealis Basin in the Northern Martian Hemisphere has replaced the Hellas Basin in the Southern Martian Hemisphere as the largest impact crater in the worlds we know of or that Pluto is no longer a planet in our solar system. Wait! How would the creationists react to the digitized era? That's a question best left to anyone's imagination.

IP Valuations - a tricky issue

My prediction is that buying and selling IPs is an area where America may still lead the world. We live in a new America where there is price pressures on everything from private jets and yachts to a bar of soap. So, we need to ask ourselves, in which sector would there be better price discovery, a good real return and a marketplace where smart investors can make money. I am not so sure about trading in the green energy certificates as I still dont know where the spread would come from, but I am more optimistic on buying and selling intellectual property (IP). IP is a tricky area - unlike commodities, it does not have a form or a shape - it is an idea and essentially we are looking at how much an idea is worth now and how much will it be worth a few years from now. We trade on those premises. While IP trading is not exactly new, valuation methods that help value these intangible assets are subject to plenty of government and legal interference -  a trend that should be avoided but nevertheless exists. In an IP world, a new IP that is patentable is always substantially different from anything existing right now. Ergo, by its very nature, the new IP poses a valuation issue. In the absence of public and financially deep trading markets, there is no market pricing to use. We, at Accuserve, think a lot on how to use various techniques to narrow in on a range but we've seen that calculation methods return a wide range of results. How does one determine that an IP right now will be useful, say, 10 years down the line? That is the tricky question. 

The Age of App Platforms

Internet businesses seem to set new management paradigms than their offline counterparts. Revenues are earned by sharing them with each other and costs are apportioned between competitors in innovative ways through clever use of hardware and software solutions. An important way of doing business currently is the App Platform. The App platforms are application servers that companies such as SalesForce.com, FaceBook, Apple, Amazon.com and others make available to people who want to target their audiences not through their products and services but through their own applications. App developers have a variety of business models to monetize including sharing application download fees with app platform providers and supplying advertising revenues and traffic. If you are a start-up seeking to build a large subscriber based business, then app platforms are a MUST as a component, if you wish to see better valuations for your business. Just as with other businesses, there are certain Internet-based businesses such as retailing where revenues may become stagnant in the new American "savings" era. Innovative revenue sharing and growth models may become a necessity now.

The Idea Game

Welcome to Shiva Badruswamy's Idea Blog. I have created this blog to write about trends I and my partners evaluate in the innovative technology, health care and energy-related industries. We have reviewed and valued hundreds of business plans in these industries. This gives us the ability to condense idea generation trends into broad market movements that may trigger venture capital fund flows into these ideas in the immediate future. While some of our views maybe speculative, most of them are based on a solid understanding of what the market participants are evaluating when it comes to next generation of technologies.

Disclaimer: Our information is designed to help readers understand what and how innovative ideas are generated. Our information should not be used in any form or manner as prospectus material to solicit offers for investment capital, buy or sell securities, or as an analyst's guidance in evaluating performance of public and private companies. Our permission is needed for reuse of our material. Please contact us at info@accuserveus.com for more details.