Sujan Rajbhandary

Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.

For this quarterly update, we bring together a couple of strands of our medtech and device industry practice. First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term. Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives. The implications for some of the larger companies in the space are probably clear-cut. The downstream reverberations to private, development stage companies may be less straightforward. Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.2022: A Brief ReviewA tumultuous year in the public markets is coming to a close. By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year.The broader medtech and devices industry largely followed suit. On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market. As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well.A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies. At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry. It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.The shift towards more caution also manifested in other measures of market sentiment and activity. Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples. The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022. By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021. The number of IPOs also slowed to a trickle.Looking Ahead to 2023 and Beyond: A Few Notes for Development Stage CompaniesNo industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones. In this context, some observations for development stage companies:An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.The sentiment shift towards more caution is shared by all investors, although the degrees will differ. Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.Wrap-upBeyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse. We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them. The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix. Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view. Even among these investors, financial terms and preferred deal structures vary considerably.For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality.In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector. Please contact us to discuss how we may be of help.For a more in-depth review of the industry, take a look at our most recent newsletter.

When an exit event is not imminent, the appropriate models to measure the fair value of a company with a complex capital stack are the Probability Weighted Expected Return Method (PWERM), the Option Pricing Method (OPM), or some combination of the two.  While the choice of the model(s) is often dictated by facts and circumstances – for example, the company’s stage of development, visibility into exit avenues, etc. – using either the PWERM or the OPM requires a number of key assumptions that may be difficult to source or support for pre-public, often pre-profitable, companies.  In this context, primary or secondary transactions involving the company’s equity instruments, which may or may not be identical to common shares, can be useful in measuring fair value or evaluating overall reasonableness of valuation conclusions.For companies granting equity-based compensation, transactions are likely to take the form of either issuances of preferred shares as part of fundraising rounds or secondary transactions of equity instruments (preferred or common shares, as part of a fundraising round or on a standalone basis).  Fundraising rounds usually do not provide pricing indications for common shares (or options on common) directly.  However, a backsolve exercise that calibrates the PWERM and/or the OPM to the price of the new-issue preferred shares can provide value indications for the entire enterprise and common shares.  While standalone secondary transactions may involve common shares, facts and circumstances around those transactions may determine the usefulness of related pricing information for any calibration or reconciliation exercise.  Calibration, when viable, provides not only comfort around the overall soundness of valuation models and assumptions, but also a platform on which future value measurements can be based.This article presents a brief discussion on evaluating observed or prospective transactions.  Not all transactions are created equal – a fair value analysis should consider the facts and circumstances around the transactions to assess whether (and the degree to which) they are useful and relevant, or not.1Fair ValueASC 718 Compensation-Stock Compensation defines fair value as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”  ASC 820 Fair Value Measurement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  While some of the finer nuances may differ slightly, both definitions make reference to the concepts of i) willing and informed buyers and sellers, and ii) orderly transactions.Notably, ASC 820 includes the directive that “valuation techniques used to measure fair value shall maximize the use of relevant observable inputsÉand minimize the use of unobservable inputs.”  We take this to mean that pricing information from transactions should be used in the measurement (valuation) process as long as they are relevant from a fair value perspective.Willing and Informed PartiesA fundraising round involving new investors, assuming the company is not in financial distress, tends to involve negotiations between sophisticated buyers (investors) and informed sellers (issuing companies).  As such, these transactions are relevant in measuring the fair value of equity instruments, including those granted as compensation.When a fundraising round does not involve new investors, the parties to the transaction are not necessarily independent of each other.  However, such a round may still be relevant from a fair value perspective if pricing resulted from robust negotiations or was otherwise reflective of market pricing.Secondary Transactions – Orderly Transactions?As they give rise to observable inputs, secondary transactions can be relevant in the measurement process if the pricing information is reflective of fair value.  Pricing from transactions in an active market for an identical equity instrument would generally reflect fair value.  In other cases, orderly transactions Ð those that have received adequate exposure to the appropriate market, allowed sufficient marketing activities, and were not forced or distressed Ð can give rise to transaction prices that are reconcilable with fair value.  Orderly secondary transactions that are relatively larger and those that involve equity instruments similar to the subject interests are more relevant.Strategic ElementsSome fundraising rounds involve strategic investors who may receive economic benefits beyond just the ownership interest in the company.  The strategic benefits could be codified in explicit contracts like a licensing arrangement.  Consideration paid for equity interests acquired in such transactions may exceed the price a market participant (with no strategic interests) would consider reasonable.  However, even as the pricing indication from such a transaction may not be directly relevant, it can be a useful reference or benchmark in measuring fair value.  For example, it may be possible to estimate the excess economic benefits accruing to the strategic investors.  Any fair value indication obtained separately could then be compared and reconciled to the price from the strategic fundraising rounds.In other instances, strategic rounds may result in the company and investors sharing equally in the excess economic benefits.  The transaction price could then be reflective of fair value, and a backsolve analysis to calibrate to the transaction price would be viable.More Complex StructuresA tranched preferred investment may segment the purchase of equity interests into multiple installments.  Pricing for such a round is usually set before the transaction and is identical across the installments, but future cash infusions may be contingent on specified milestones.  Value of a company usually increases upon achieving technical, regulatory, or financial milestones.  Even when future installments are not contingent on specified milestones, value may increase over time as the company makes progress on its business plan.  Pricing set before the first installment tends to reflect a premium to the value of the company at the initial transaction date as it likely includes some expectation of potential economic upside from future installments.  On the other hand, the same price may reflect a discount from the value of the company at future installment dates as the investments are (only) made once the economic upside is realized.  Accordingly, a reconciliation to pricing information from these fundraising rounds may require separate estimates of the expectation of future upside (for the initial transaction date) and future values implied by the initial terms of the transaction (for later installment dates).Some fundraising rounds involve purchases of a mix of equity instruments across the capital stack (i.e. different vintages of preferred and/or common) for the same or similar stated price per share.  Usually, common shares involved in mixed purchases represent secondary transactions.  From a fair value perspective, the transaction could be relevant in the aggregate and provide a basis to discern prices for each class of equity involved (considering the differences in rights and preferences among the classes).  In other instances, either the company or the investor may have entered into a transaction for additional strategic benefits beyond just the economics reflected in the share prices.  Depending on whether the buyer or the seller expects the additional strategic benefits, reported pricing may exceed the fair value of common shares or understate the value of the preferred shares.  In yet other instances, mixed purchases at the same or similar prices may indicate a high likelihood of an initial public offering (IPO) in the near future.  Typically, preferred shares convert into common at IPO and only one class of share exists subsequently.Timing of Transactions and Other EventsPerhaps obviously, for both secondary and primary transactions, more proximate pricing indications are generally more directly useful for fair value measurement.  Older, orderly transactions involving willing and informed parties would have been reflective of fair value at the time they occurred.  If a more recent pricing observation is not available, current value indications could still be reconciled with the older transactions by considering changes at the company (and general market conditions) since the transaction date.Planned future fundraising rounds could also provide useful information.  In addition to the factors already addressed, a fair value analysis at the measurement date would need to consider the risk around the closing of the transaction.Besides the usual transactions, other events that occur subsequent to the measurement date could still have a bearing on fair value.  Future events that were known or knowable to market participants at the valuation date should be considered in measuring fair value.  Events that were not known or knowable, but were still quite significant, may require separate disclosures.Special Case – IPOsAn example of a special event on the horizon is an impending IPO.  An IPO is usually a complex process that is executed over a relatively long period.  At various points during the process, the company’s board or management, or the underwriter (investment banker) may project or estimate the IPO price.  These estimates may change frequently or significantly until the actual IPO price is finalized.  Even the actual IPO price may be subject to specific supply and demand conditions in the market at or near the date of final pricing.  Subsequent trading often occurs at prices that vary (sometimes drastically) from the IPO price.  For these reasons, estimates or actual IPO prices are unlikely to be reflective of fair value for pre-IPO companies.Setting aside the uncertainties and idiosyncrasies around the process, an IPO provides ready liquidity for investors and access to public capital markets for the company.  The act of going public ameliorates the risks associated with the lack of marketability of investments in a company.  Easier access to public markets generally lowers the cost of capital, which would engender higher enterprise values.  Accordingly, fair value of a minority equity interest prior to an IPO is generally perceived to be meaningfully different from (estimates of) the IPO price.ConclusionIncorporating information from observed or prospective transactions can help calibrate the PWERM or the OPM (or other valuation methods), along with the underlying assumptions.  However, a valuation analysis should evaluate the transactions to assess whether they are relevant.  Even when they are not directly relevant, transactions can help gauge the reasonableness of valuation conclusions.Valuation specialists are fond of thinking their craft involves a blend of technique and judgment.  The specific mechanics of models and methods, and related computations, represent the technical aspect.  There is certainly some judgment involved in developing or selecting the assumptions that feed into the models.  Judgment plays a bigger role, perhaps, in weaving together the models, assumptions, valuation conclusions, and other facts and circumstances, including transactions, into a coherent and compelling narrative.Contact Mercer Capital with your valuation needs. We combine technical knowledge and judgment developed over decades of practice to serve our clients.1   The discussion presented in this article is a summary of our reading of the relevant sections in the following:Valuation of Privately-Held-Company Equity Securities Issued as Compensation, AICPA Accounting & Valuation Guide, 2013Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Working Draft of AICPA Accounting & Valuation Guide, 2018 Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

A logical fallacy occurs when one makes an error in reasoning.Causal fallacies occur when a conclusion about a cause is reached without enough evidence to do so.The cum hoc (“with this”) fallacy is committed when a causal relationship is assumed because two events occur together.When it comes to financial reporting, an example of this fallacy would be assuming that goodwill cannot be impaired unless the company’s shares are trading below book value.This is a tempting fallacy–especially as the U.S. economy is continuing a long expansion, companies are posting solid earnings, and valuations are reaching new highs.The S&P 500 increased 19% in 2017 and the Nasdaq was up 28%.In these market conditions, goodwill impairment probably does not seem like a pressing concern.After all, goodwill is considered impaired only when fair value drops below carrying value, right?While this is true, accounting standards require that goodwill be tested for impairment at the reporting unit level.Impairment relates to a reporting unit’s ability to generate cash flows.This means that a company’s goodwill can be impaired at the reporting unit level, even as its stock trades above book value.This was the case for multinational conglomerate General Electric last year.GE had a tumultuous 2017 as the company’s CEO and CFO departed, the dividend was cut, and a corporate restructuring was announced.The salient event for the purposes of this article is a $947 million impairment loss recorded in its Power Conversion Unit during the third quarter of 2017.This unit is what became of GE’s 2011 $3.2 billion acquisition of Converteam, an electrical engineering company.According to the company’s 2017 annual report, the causes for this impairment included downturns in marine and oil and gas markets, pricing and cost pressures, and increased competition.GE’s stock felt the turmoil, falling 42% in 2017.Shares traded at $17.25 at their lowest point, implying a market capitalization of $150.5 billion.But even at this point, GE’s stock was not trading below book value ($64.3 billion at the end of 2017).GE’s market value exceeded book value of equity by $86.2 billion.So while impairment and market value/share price are related, it is not safe to assume that there is no impairment if the stock trades above book value.Another notable example is CVS Health.The company made headlines with one of the largest mergers of the year when it announced the acquisition of insurer Aetna, Inc. for $69 billion in December 2017.A smaller, less widely reported transaction transpired in November when the company announced the sale of its RxCrossroads reporting unit to McKesson Corp. for $735 million.This unit was part of CVS’s 2015 acquisition of nursing home pharmacy Omnicare, Inc. and provided reimbursement assistance and sales operation support, among other services.In the second quarter of 2017, CVS recognized a $135 million impairmentcharge related to this reporting unit.As with GE, CVS never traded below book value.CVS stock declined approximately 8% in 2017 and hit a low of $66.45 on November 6.The market capitalization at this point was approximately $67.7 billion.The book value of CVS equity was $34.9 billion at September 30, 2017 and $37.7 billion at year-end.The above examples expose the fallacious idea that a company can avoid impairment charges simply because its stock trades above book value.That is not to say that there is no relationship between the two; an impairment charge can certainly signal the market and affect share price, or a decline in share price may foreshadow an impending impairment charge.Because goodwill must be tested for impairment at the reporting unit level, impairment may occur even when the company’s market cap exceeds book value. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

Concurrent with Madeleine Harrigan’s post last week about IPOs being the new private equity downround, the financial reporting group at Mercer Capital published an interview with the head of the group, Travis Harms, on the difficulties mutual funds face in valuing level 3 assets (think Square). The following is an excerpt from that interview.With respect to portfolio valuation, who are your clients and what services do you provide? In our portfolio valuation practice, clients cover the spectrum from debt-focused funds, to hedge funds, traditional private equity funds, venture funds, and sector-focused credit and equity funds. Despite the diversity of strategies, what they all have in common is the need to develop reliable, defensible fair value marks for hard-to-value assets in a real-time reporting cycle. That reporting cycle varies by client – we mark some assets on a monthly basis, while we look at others annually. The frequency with which we mark assets is generally a function of the fund manager’s ability to develop interim marks on their own – do they have the requisite expertise and staffing to develop and document reasonable interim marks? Now, of course, the fund manager has the expertise to value assets. However, the fund manager’s valuation objective is to determine “intrinsic” or “investment” value, which may well differ from the prevailing market consensus. That is not the objective of fair value reporting, though. Fair value is not the fund manager’s price target based on his investment thesis. It is a particularly defined standard: fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Developing and documenting the corresponding market participant inputs can be time-consuming and requires a different perspective than the fund manager is accustomed to using. Sometimes we are developing our own independent estimates of fair value from scratch; other times we are examining the fund manager’s own estimates for the purpose of providing positive assurance that the marks are reasonable. Regardless of the scope of our work, documenting, presenting, and defending our conclusions to auditors and, potentially, regulators is always part of our job. Looking to the VC markets a bit, you have commented on the Unicorn phenomenon and suggested that from a valuation perspective, “What’s obvious isn’t real, what’s real isn’t obvious.” What do you mean? What we mean by that is that – while the headline valuation ascribed to a company following a fundraising round is obvious (price x fully-diluted shares outstanding), that is not the real value of the company. What is less obvious, but considerably more real, is that the price per share in the most recent round reflects all of the rights and economic attributes of that share class. Those rights and attributes are not the same for all of the other shares included in the fully diluted share count. It’s like applying the per-pound price for filet mignon to the entire cow – you can’t do that because the cow includes a lot of other stuff that is not filet. In the same way, the “obvious” pxq calculation overstates the value of an early-stage company. Now, no doubt the values of many “unicorns” are substantial, even when calculated correctly – but the real values are not nearly as obvious as the often breathless headlines would suggest. Last week, a Wall Street Journal article elaborated on some of the difficulties that mutual funds face in valuing their investments in startups. Based on your experience with providing periodic fair value marks for VC funds, what are some of the elements that go into valuing such investments? What are some of the pain points? Valuing startup investments, including “unicorns” such as those mentioned in the Wall Street Journal article, requires developing a thorough understanding of the economics of the most recent funding round, which provides a market-based “anchor” for valuation at subsequent measurement dates. What we find most effective is to build our valuation model so that it corroborates the “anchor” value as of the date of the most recent external funding round. Once our model is appropriately calibrated, we can then develop appropriate market participant model inputs for the measurement date that take into account changes in markets, company performance, and prospects for future exit with regard to timing, amount, and form. Valuing these investments is particularly challenging given the illiquidity of the securities. When observable transactions occur only sporadically or at long intervals, it can be difficult to assess how changes in the market and company prospects will influence value. The longer the holding period – in other words, as you move from days to months to years – the greater the uncertainty regarding reasonable inputs and the wider the range of potential outcomes. Things become even more difficult when you layer in the unique features of many of these securities, such as liquidation preference, conversion, participation, and other rights and features. Finally, the WSJ article discusses the fact that there is variation, sometimes substantial, in the valuation marks provided by different investors in the same company. Is that troublesome? Is it troubling that different reasonably informed investment professionals come to different good faith estimates of the fair value of the securities we’ve been discussing? No. As we mentioned previously, illiquidity necessarily increases uncertainty. This is a phenomenon that you can observe even in securities that trade in markets – the less liquid and shallower the market, the wider the bid-ask spread will be. Even if you follow a rigorous calibration process like we outlined earlier, there is uncertainty about inputs. For example, you may know – on the basis of an observed market transaction – that a company’s value was $40 at a particular date, but what you still cannot directly observe is whether that was 8 times 5 or 10 times 4. Those unobservable inputs will necessarily breed good faith differences of opinion as the $40 value becomes stale with the passage of time. That is not to say that anything goes – there is a range of reasonable conclusions. But no, different estimates of fair value for these securities are not in themselves troubling. A different question, whether it is troubling – given this valuation uncertainty – that an open-end mutual fund owns such securities is for the regulators to decide. It may be that the fair value estimates are reasonable, and reasonably different, but those differences are simply not tolerable from a regulatory standpoint. That, however, is ultimately not a valuation question.Related LinksUnicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t ObviousHow to Value Venture Capital Portfolio InvestmentsValuation Best Practices for Venture Capital FundsMutual Funds Flail at Valuing Hot Startups Like Uber (subscription required)Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

The following outlines our process when providing periodic fair value marks for venture capital fund investments in pre-public companies.Examine the most recent financing round economicsThe transaction underlying the initiation of an investment position can provide three critical pieces of information from a valuation perspective:Size of the aggregate investment and per share price.Rights and protections accorded to the newest round of securities.Usually, but not always, an indication of the underlying enterprise value from the investor’s perspective. Deal terms commonly reported in the press (example) focus on the size of the aggregate investment and per share price. The term "valuation" is usually a headline-shorthand for implied post-money value that assumes all equity securities in the company’s capital structure have identical rights and protections. While elegant, this approach glosses over the fact that for pre-public companies, securities with differing rights and protections should and do command different prices. The option pricing method (OPM) is an alternative that explicitly models the rights of each equity class and makes generalized assumptions about the future trajectory of the company to deduce values for the various securities. Valuation specialists can also use the probability-weighted expected return method (PWERM) to evaluate potential proceeds from, and the likelihood of, several exit scenarios for a company. Total proceeds from each scenario would then be allocated to the various classes of equity based on their relative rights. The use of PWERM is particularly viable if there is sufficient visibility into the future exit prospects for the company. The economics of the most recent financing round helps calibrate inputs used in both the OPM and PWERM.Under the OPM, a backsolve procedure provides indications of total equity and enterprise value based on the pricing and terms the most recent financing round. The indicated enterprise value and a set of future cash flow projections, taken together, imply a rate of return (discount rate) that may be reasonable for the company. Multiples implied by the indicated enterprise value, juxtaposed with information from publicly traded companies or related transactions, can yield valuation-useful inferences.Under the PWERM, in addition to informing discount rates and providing comparisons with market multiples, the most recent financing round can inform the relative likelihood of the various exit scenarios. When available, indications of enterprise value from the investor’s perspectives can further inform the inputs used in the various valuation methods. In addition to the quantitative inputs enumerated above, discussions and documentation around the recent financing round can provide critical qualitative information, as well.Adjust valuation inputs to measurement dateBetween a funding round and subsequent measurement dates, the performance of the company and changes in market conditions can provide context for any adjustments that may be warranted for the valuation inputs. Deterioration in actual financial projections may warrant revisiting the set of projected cash flows, while improvements in market multiples for similar companies may suggest better pricing may be available for the company at exit. Interest from potential acquirers (or withdrawal of prior interest) and general IPO trends can inform inputs related to the relative likelihood of the various exit scenarios.Measure fair valueMeasuring fair value of the subject security entails using the OPM and PWERM, as appropriate and viable, in conjunction with valuation inputs that are relevant at the measurement date. ASC 820 defines fair value as, "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."Reconciliation and tests of reasonablenessA sanity check to scrutinize fair value outputs is an important element of the measurement process. Specifically as it relates to venture capital investments in pre-public companies, such a check would reconcile a fair value indication at the current measurement date with a mark from the prior period in light of both changes in the subject company, and changes in market conditions.Mercer Capital assists a range of alternative investment funds, including venture capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors. Call us – we would like to work with you to define appropriate fund valuation policies and procedures, and provide independent opinions of value.