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.

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.

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.