As a company grows and develops, many business owners often begin issuing stock or options as part of their employee compensation. The benefits of this are clear and varied:
The difficulty with stock compensation for privately held companies is determining the value of the stock or the strike price of the option. The IRS pays particularly close attention to this, as this value establishes the tax cost basis for future taxable gains, as well as current income tax and payroll tax burdens.
The risk that management or owners of a business might be manipulating the value of the stock by issuing deeply discounted stocks in order to minimize income taxes is a prominent red flag for IRS auditors. Likewise, when issuing GAAP financial statements, the manipulation of stock compensation expense line items is an area of focus for auditors as it directly impacts company earnings.
In light of this scrutiny surrounding stock compensation, the best way to address the inherent risks and headaches of stock valuation is by hiring a qualified, experienced valuation specialist to perform an independent third-party valuation.
Preferred Financing Rounds Impact on Common Value
One of the struggles of a fledgling company is raising capital. Many companies do this by issuing equity to outside investors in the form of preferred shares in the company. As management or ownership considers raising funds by issuing equity to outside investors, the impact to the common shareholders should be considered.
While an option-holder may enjoy seeing a lower exercise price on newly issued options, the fact that previously issued options might now be “underwater” may ultimately lead to reduced morale, loss of economic value (if the options expire), and questions regarding the growth prospects of the company.
After analyzing over 1,000 of our own engagements, Scalar’s team has uncovered some helpful insights regarding the fair value of common stock compared to the price per share of the most recent preferred round.
While not an official method for measuring and reporting the value of common stock, these insights may be helpful for management as they negotiate the preferred round of financing and its impact on the common shareholder.
The Good, the Bad, and the Normal
Analyzing over 1,000 common stock valuation engagements from the year 2016 to early 2017, Scalar’s team has drawn some interesting conclusions related to the value of common as it relates to the most recent round of preferred.
Of these engagements, 537 valuations were directly concurrent with a round of preferred equity financing, and even relied on the preferred round for the implied value needed to determine the value of common. An additional 84 engagements also incorporated a recent preferred financing transaction, but calculated the implied value using a combination of other methodologies as well.
The preferred series included seed-stage equity, all the way up to late-stage Series G and H financing.
Below is a summary of results by financing round:
As shown in the data above, the median fair market value of common compared to the most recent price of preferred tends to be around 30 percent. The relevant range, beginning at the 25th percentile, trends around 20-25 percent and goes up to 35-40 percent at the 75th percentile.
These correspond with following pre-money valuation ranges:
While this is not a substitute for a robust independent valuation, this data provides some useful insight into probable outcomes under normal terms and circumstances.
Outliers: Torpedos and Rocket Ships
Every now and then we come across valuations that don’t behave normally. Understanding what factors drive these torpedos and rocket ships may prove valuable as a business owner negotiates the terms of a preferred round of financing.
When looking at torpedos (when the value of common as a percent of preferred is very low) there are a couple features that have the biggest impact. In Scalar’s data set, the two preferred features which tend to impact the value of common the most are Participation Rights and Liquidation Preference.
In situations where both of these features are present, the value of common has been pushed down the most, resulting in the lowest value of common to a preferred percentage. To a lesser extent, seniority also factors into the impact on the value of common, but instances of this for early preferred series was less frequent.
For the rocket ships (when the value of common versus preferred is above the 75th percentile) the factors which contribute to these relative effects are less obvious. These are usually driven more by company performance and relative growth as opposed to features of the preferred. Generally, the preferred series had standard rights and features, such as 1.0x liquidation preference and conversion, as well as no participation rights. The absence of further protective rights helps the value of common to be as high as possible.
In the instances where the value of common is 50 percent of preferred or higher, this has been driven by the high implied equity value of the company as a whole. As the value of the company exceeds the total liquidation stack, the value of common begins to increase dramatically relative to the preferred.
As the value begins to reach or exceed a level where the preferred are incentivized to convert to common during a transaction, we see a convergence of the values between the common and preferred share classes.
Calculating Precise Values
While it is difficult to estimate the exact value of common without doing a full valuation, the indications above can provide useful information to business owners and managers. This can be particularly helpful when negotiating a round of financing and determining the general implications for the value of the common shareholders.
While these topics can quickly become very complex, the analysts at Scalar are highly experienced and able to answer questions and provide insights regarding all areas of valuation, including the fair value of common stock as a percent of preferred. Scalar’s team has performed thousands of valuations for a variety of privately held companies, ranging from the small start-up to the large and established, and through all stages of development up to initial public offerings.
This article is purely informative, and Scalar does not accept any responsibility for action taken based on the content of this article.