Last time, I argued that the standard way of calculating the pre- and post-money valuation of a private venture-backed company – the Standard Venture Valuation Model or SVVM – almost always overvalues the company. By how much is hard to say, but in many cases, the amount can be significant.
Today, we’ll look at the “so what” question about the SVVM. Does it matter that the SVVM is biased on the high-side? If so, how, and what should entrepreneurs and investors do about it?
The SVVM makes good copy. At the same time, most insiders, at least, know it’s just an arbitrary and capricious way of keeping score pending the exit, when everyone will find out just how much more valuable various classes of preferred stock are than common stock. You can certainly make a “no harm, no foul” argument for the SVVM, so long as everyone realizes its limitations. That said, those limitations do introduce some business complications for companies and investors alike.
For companies, the SVVM sets up two problems, which are both related to employee equity incentives.
First, while emerging companies generally prefer offering employees equity incentives at the lowest possible price, the tax code strongly encourages pricing incentives at the fair market value (FMV) of the common stock on the date of grant. That means companies must calculate the FMV of common shares in a manner that passes IRS scrutiny. Most companies accomplish that by engaging a valuation professional employing the guidelines in Section 409A of the tax code as the basis for valuing the common stock. The cost of a 409A valuation typically ranges from a couple of thousand dollars (for early stage companies with simple capital structures) to tens of thousands of dollars (for later stage companies with complex capital structures).
409A valuations typically result in a FMV for the common significantly below the company’s most senior securities. The discount can be significant (50% or more). Should the SVVM be adjusted – reduced - to reflect the 409A valuation of the common? Perhaps, but 409A valuations generally do not value any shares of the company other than the common shares. For that matter, different valuation professionals employing the same 409A guidelines can easily come up with different values for the common shares. And 409A valuations for particular companies – while not generally difficult for an intrepid reporter to track down – are not widely available. In any event, I’ve yet to see a popular press deal valuation report that adjusted the SVVM to reflect any discounts on the value of common or junior preferred shares, 409A-driven or otherwise.
The equity incentive pricing issue also comes up in exit transactions, most prominently in the IPO exit scenario. This time, the SEC, not the IRS, is the heavy. It will look back at all the equity incentives granted by the company, and to the extent any of them were granted at less than FMV (something the SEC figures out for itself, independent of any 409A valuations), the SEC will require the company to report an earnings hit for those incentives. While not a cash expense, the optics can have a material negative impact on how investors value the company at the exit. Just ask Uber, which just last week reported incentive equity-related losses related to it’s IPO in excess of $3 Billion – and saw it’s stock drop 6% on the news.
For venture capital funds, the SVVM complicates how they account for (and report) their performance to their investors (and prospective investors). For both purposes, reporting markups on their investments as they gain value – “marking to market” in accounting jargon – is tempting. And the SVVM provides a nice set of rose-colored glasses to do that. But with rare exceptions (problematic exceptions at that), there is no meaningful market for securities of private venture-backed companies and, thus, no basis for “marking to market” the value of junior preferred shares. A valuation based on the SVVM – certainly in a way which suggests that valuation reflects reality – is most often somewhere between an inch and a mile from reality.
Two things should be clear at this point. The SVVM is a simple algorithm that yields a precise answer that is easily understood and makes for easy comparisons between companies and rounds of financing. Second, the SVVM almost always overvalues companies. Finally, while companies are now and again obligated to value common shares for purpose other than “keeping score,” those values are themselves obtuse and only apply to common shares.
Despite its shortcomings, the Standard Venture Valuation Method has been the way industry insiders, abetted by the popular press, to keep score since the early days of the venture business. For industry insiders who appreciate its limitations, and thus take its sunny prognostications with an appropriately large grain of salt, I suppose a noblesse oblige “no harm no foul” attitude works. Still, it remains incumbent on those with that appreciation to make sure those lacking that appreciation are not caught unawares when unfolding events, as they so often do, put the lie to it.