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.