In conducting this valuation, the rule of thumb – “common stock should be twenty percent of preferred” is brought up regularly by clients. It is likely a vestige of days prior to IRC 409A when boards or company counsel would simply apply a heuristic of pricing options for common shares at 10% or 20% of the price of preferred shares – recently paid by an angel investor, venture capital firm, or private equity firm. The latitude to use a simple heuristic went out the door with IRC 409A.
Though the latitude is gone, the rule of thumb persists in the minds of many board members, attorneys, and entrepreneurs. Just as with any rule of thumb or generalization, the majority of cases do not coincide exactly and, in some cases, fall well outside the norm. Understanding the assumptions behind this notion and how deviations from said assumptions affect value is often misunderstood. There are more obvious factors that directly influence value as well as factors working behind the scenes of the analysis.
Although some may believe this rule applies to all approaches, we will specifically look at it in context of the Backsolve methodology as it is the only method where the most recent round of preferred stock is a main driver of the concluded value. The Backsolve uses the Option Pricing model which is sometimes referred to as the Black-Scholes model. This model sets the implied price of the most recent round to its original issuance price and then uses the Solver function in Excel to iterate to the implied equity value of the company. This equity value is in turn run through a waterfall to calculate the value of common stock. In order to correctly set up this model, the following pieces of information are needed:
- Term to exit or maturity
- Risk-free rate
- Capitalization table and the associated economic rights
Term to exit or maturity (or liquidation date) most often falls in the three to five-year range. Often investors into start-ups are looking for a return within this time frame unlike other longer held positions. As a general rule, a shorter term leads to a lower price due to behavior of the Black-Scholes equation. There are limitations to the model as Warren Buffet notes: “I believe the Black–Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued… The Black–Scholes formula has approached the status of holy writ in finance … If the formula is applied to extended time periods, however, it can produce absurd results.”
For privately held companies, volatility is estimated by looking at public comparable companies and their associated volatilities. Obviously, this is industry specific and the differences between the public companies and the subject company should be taken into consideration when estimating this input. In the context of a valuation, the higher the volatility, the higher the concluded price.
The risk-free rate is one of the more objective inputs and is usually approximated as the yield of a U.S. 20-year treasury bond.
Now comes the input with massive variations and big implications – the capital structure of the company and the rights that belong to the different securities. When people refer to the twenty percent rule, they are most likely assuming “West Coast terms.” This means that preferred is entitled to receive one times their original issue price, no dividends, do not participate, and convert on a one-to-one basis. When agreed upon terms deviate from this, however, values can be altered quite a bit. For example, if a company raised a round with a 2.0x liquidation preference, the value of common stock would decrease given the more onerous terms. Similarly, when accruing dividends or participation come into play, more of the value of the company is given to preferred by way of their inherent economic rights and less is left over for common stock. Additionally, there are a couple more obscure items that may further muddy the rule of thumb. According to the AICPA Accounting & Valuation Guide, “financing rounds that are senior to previous rounds may not provide a good indication of the equity value for the enterprise because they may result in models that do not appropriately capture the liquidation preferences for the junior preferred securities.” This does not mean that if a company has what is referred to as stepped preferences, the Backsolve methodology should not be used but that this factor should be taken into consideration when concluding to a value and other methodologies may be needed. Lastly, the percent of the capitalization table that is preferred stock has some unique implications. Occasionally we see earlier stage companies (Series Seed or Series A) that have sold a significant percent of the company. In doing so, their capital structure is more similar to a company in the Series C or Series D stage. This in turn usually results in a higher value of common stock as a percent of preferred which is normal in later financings but often unexpected in earlier rounds.
All of these items play a role in determining the value of the common stock in a 409A analysis. It is crucial to take these into consideration when opining on the appropriate strike price of the options that will be granted to employees. The analysis may show that common stock is twenty percent of the most recent financing round, however, most of the time it is not. There are many assumptions that go into the Black-Scholes model and all have their effect on value. Given the number of variables and their interactions with each other it is very difficult to have a generalization concerning the fair value of common stock. Given people’s aversion to uncertainty, many don’t like to hear the most accurate statement describing the value drivers which is… “it depends.”