This week, we feature two stories & one study, each of which highlights the need to analyze venture transactions in their entirety, rather than price.
Equity-Based Compensation Valuation
From our perspective, contractual (and/or customary) rights and preferences allocated among the various parties to a transaction define the parameters within which we operate while measuring fair value. That being said, the extent to which differential shareholder rights can or cannot be (legally or normatively) enforced may inform the assumptions and expectations of market participants, be they VC investors or startup employees. And those market participant perspectives will inform the valuation analysts’ assumptions and methods.
In October 2015, the SEC adopted final rules governing the crowdfunding of startups and Regulation Crowdfunding was issued in May 2016. Subsequently, the SEC has issued investor bulletin(s) to educate potential investors on the new investing opportunities. The new rules allow non-accredited investors to invest directly in startup (and other) companies that can raise up to $1 million every twelve months through crowdfunding. At the time the SEC first proposed the rules in October 2013, we speculated that crowdfunding might turn into a new source of capital for small businesses. Now, a year after Regulation Crowdfunding came into effect, we take a look at the state of crowdfunding.
A couple of articles in the Wall Street Journal last week highlighted challenges of managing and investing in early-stage companies. From a valuation standpoint, the articles are timely reminders of the importance of cash burn rates, dilution factors, and exit probabilities in measuring the fair value of startups.
On the one hand, it is not difficult to imagine that tax changes would have some effect, at the margin, on the mix of the various forms of employee compensation – current cash, deferred/contingent cash, or equity scrips. On the other hand, it is difficult to conjecture a causal relationship between changing financial reporting requirements and lower aggregate (risk-adjusted) take-home worker compensation.
The motivation behind incentive pay at the startup level is that in order for the employees to strike it rich, the company must succeed by hitting certain milestones. This aligns employees’ personal goals with the company’s overall success. The slight misalignment of this structure, however, can lead to employee turnover at companies.
We have published a collection of these posts in a book entitled “Market Participant Perspectives: Selections from Mercer Capital’s Financial Reporting Blog.” For our existing clients and blog subscribers, we hope that the book uncovers a post or two of interest that you might have missed the first time around. For clients that we haven’t met yet, there’s probably no better introduction to our team than the collection of posts in this book.
In a typical service provider-customer relationship, the provider delivers a service and the customer delivers cash. Upon delivery, both parties are happy and move along to the next transaction. However, a trend that gained popularity in the early 2000s adds an extra level of complexity to this seemingly simple business relationship – equity payments.
The debate over the use of non-GAAP performance measures continues. Even as the prevalence of these items grows in the financial reports of public companies (and those that want to be), cautionary tales of the uses and abuses of such metrics garner headlines. A recent New York Times piece entitled “Fantasy Math Is Helping Companies Spin Losses Into Profits” pretty much sums up one side of the issue with its headline alone.
We continue our discussion on the OPM, addressing the model from a more qualitative perspective and evaluating the model’s use and potential misuse in practical application.
The option pricing model, or OPM, is one of the shiniest new tools in the valuation specialist’s toolkit. While specialists have grown accustomed to working with the tool and have faith in the results of its use, many non-specialists remain wary, as the model – and its typical presentation – has all the trappings of a proverbial black box. The purpose of this post is to clarify the fundamental insight underlying the model and illustrate its application so that non-specialist users of valuation reports can gain greater comfort with the model. In Part 2, we will provide address some qualitative concerns regarding use of the method in practice.
As mutual fund flows continue to favor passive strategies, some active fund managers are beginning to look to alternative asset classes to augment returns and generate sustainable alpha. Since open-end funds need to calculate NAV on a daily basis, the inclusion of illiquid venture capital investments in liquid funds shines a brighter spotlight on fair value measurement.
Despite a strong year in the FinTech sector, IPO pricing is always tricky, especially in the tech space. In this post, we consider Square’s IPO and how preferences associated with shares affect valuations.
In prior blog posts, we noted a couple of regulatory changes that eased some restrictions on (relatively small) securities-based fundraising from a wide base of investors: Regulation A+ and crowdfunding. This blog post provides an update on crowdfunding, discussing the rules and risk items with valuation implications in the SEC’s investor bulletin.
There’s something about nature that abhors a vacuum. Right now that vacuum seems to be the imbalance between the public and private markets, with the latter attracting maybe too much interest since the credit crisis, at the expense of the former. Blame fair value accounting or Sarbanes-Oxley or the plaintiff’s bar, but it has been some time since being public was actually considered a good thing. With interest running high in the “alternative asset space” and cheap debt for LBOs, the costs of being public have not been particularly worthwhile. This situation is not sustainable, and was never meant to be. Family businesses can stay private forever, but institutional investors eventually need the kind of liquidity that can only come from the breadth of ownership afforded by established public markets. Valuations are never really proven until exposed to bids and asks.
What do IRS examiners look for when auditing filings with equity-based compensation plans? The IRS recently released its Equity (Stock)-Based Compensation Audit Techniques Guide, which offers an opportunity to see how the IRS views equity-based compensation arrangements. The guide is intended to assist IRS examiners, as well as to provide insight to corporate and individual taxpayers. Our overview of the Guide is presented in this post.
In the two short years since Aileen Lee introduced the term “unicorn” into the VC parlance, the number of such companies has steadily increased from the 39 identified by Lee’s team at Cowboy Ventures to nearly 150 (and growing weekly) by most current estimates. Pundits and analysts have offered a variety of explanations for the phenomenon, with some identifying unicorns as the sign that the tech bubble of the late 1990s has returned under a different guise, others attributing the existence of such companies to structural changes in how innovation is funded in the economy, and the most intrepid of the group suggesting that the previously undreamt valuations are fully supported by the underlying fundamentals given the maturity and ubiquity of the internet, smart phones, tablets, and related technologies.
It is easy to see how employees receiving restricted shares and making a Section 83(b) election can benefit if the price of the stock rises between the grant and vesting dates. An 83(b) election may appear especially appealing to (early stage) startup employees who tend to be (preter) naturally optimistic about the prospects of their employer companies. However, the benefits of a Section 83(b) election – especially after consideration of the risks involved – may be less significant than originally anticipated. Three conditions (often outside the control of the employees) must be met for an 83(b) election to provide a (risk-adjusted) advantage: (1) Securities awarded as compensation have relatively low values at the time of grant; (2) the exit event for the employer company, or other transactions that may provide liquidity to the employees, occurs at relatively high implied valuations; (3) employees remain employed at the granting company until the awards vest. This blog post will primarily address the first condition.
During the 1990s debate over the status of stock options as a corporate expense, the big technology companies argued passionately that, since stock option grants to employees don’t ding the corporate checkbook, they should not be recognized as an expense. Despite winning the initial battle (SFAS 123), the tech companies ultimately lost the war (SFAS 123R). Regardless of the ongoing debate about how best to measure earnings, stock-based compensation is a tool used by companies of all sizes and in all industries. In order to deliver the most reliable information to investors, companies need to carefully evaluate the value of such compensation packages when granted.
On July 1, the SEC proposed new rules to require public companies to clawback certain types of incentive-based executive compensation if the award was improperly given due to accounting misstatements. For example, if an executive received a bonus based on the company achieving a revenue target and it is subsequently determined that revenue was misstated, the bonus would be subject to clawback.
Section 409A applies to all companies offering nonqualified deferred compensation plans to employees. We are not attorneys, so we will leave the legal minutiae of that definition for others to grapple with, noting only that generally speaking, a deferred compensation plan is an arrangement whereby an employee (“service provider” in 409A parlance) receives compensation in a later tax year than that in which the compensation was earned. “Nonqualified” plans exclude 401(k) and other “qualified” plans.
In this post we describe our process when providing periodic fair value marks for venture capital fund investments in pre-public companies. This process includes examining the most recent financing round economics, adjusting valuation inputs the measurement date, measuring fair value, and reconciling and testing for reasonableness.
Estimating the fair value of stock-based compensation and accounting for it properly can be complex. This post discusses the “rest and vest” scenario through the lens of the HBO program, Silicon Valley.
For privately held companies (particularly those sponsored by private equity and venture capital funds), getting the valuation process right the first time for equity compensation grant compliance is always the least expensive route in terms of both direct and indirect cost.
- Bankruptcy and Restructuring Advisory
- Equity-Based Compensation Valuation
- Fair Value
- Impairment Testing
- Portfolio Valuation
- Purchase Price Allocation