It’s well known within the industry that producing a great valuation can be as much an art as it is a science. In addition to extensive financial theory, academic training, and modeling prowess, valuation experts must be able to tell the ‘story’ of a valuation. This story aspect is vital because no matter how much data is readily available, there are always aspects of the valuation that require a gut check based on real-world experience. Over decades past, these gut checks developed into certain rules of thumb (or ‘valuation myths’) which simplified the valuation, tax planning, and financial reporting processes. The most pervasive of these myths by far has been the concept of Common to Preferred Ratios.

For those not familiar with this particular wives’ tale, let us explore some of the mythology:

At the turn of the millennium, stock-based compensation and their associated expenses were treated with a relatively blasé attitude by both the SEC and the IRS. At this time, personal computers were still on their meteoric rise within mainstream society, the Dot Com bubble and Y2K loomed ahead, and files were saved on floppy discs. In other words, many of the modeling and computing resources available today were still in their relative infancy.

Because the technological resources and expert guidance for everyday accounting efforts were still being adopted, many companies had difficulty assigning value to these derivative securities. Only the largest companies attributed adequate attention to the effort, and as such, many companies found loopholes in the system in order to hide profits from the IRS, the SEC, and in many cases, the company’s own shareholders (we’re all looking at you, Enron).

For public companies valuing option issuances, they had only to reference current market prices on their own securities. For private companies however, establishing the value of common stock was a much less clear process. Many of these companies were growing quickly, raising preferred financing rounds every year or two, and operating at a loss in order to magnify growth efforts. Without utilizing the option pricing models of today, and without regulation forcing their adoption, boards decided on a simplified approach to valuing these securities.

After raising a preferred stock round, boards would simply attribute value to common stock based on a certain percentage of the most recent preferred round’s stock price. If Company XYZ’s Series Seed shares were priced at $1.00, boards would value the Common at 10% of preferred, or $0.10. For Series A it could go to 15%, Series B to 20-25% and so on as the Company grew. This virtually guaranteed that option holders would receive attractive payouts upon an exit and kept tax and financial reporting exercises for privately held companies uncomplicated.

This premise sounds reasonable enough. Common falls last in liquidation preference, and can be diluted heavily by preferred stock participation and dividend rights. Combined with a limited market for common stock investors, these discounts became the standard amongst many VC investors and corporate lawyers. But in a post-Enron world, this standard no longer clears the bar.

In 2000, Enron executives moved $32 million out of deferred compensation accounts. Two years later, when the energy company went bankrupt, this left 21,000 other employees without two-thirds of their 401(k) savings after the company’s stock plunged $1 billion. This move was legal at the time, but Enron’s executives became the face of corporate greed, prompting a congressional inquiry and new IRS regulations around deferred compensation benefits. This new law, section 409a of the Internal Revenue Code, became part of the American Jobs Creation Act of 2004. In essence, this law now required deferred compensation benefits (such as stock options) to be issued, reported, and expensed at their fair market value (FMV). And this FMV was subject to increased IRS audit inquiry. Suddenly, these ‘rules of thumb’ didn’t meet the requirement for fair market value.

So why do companies continue to cling to them, and why are they unreliable indicators of FMV? It is true that many VC-backed companies tend to follow a similar path when raising money, but those that deviate at all from the norm will find much more variability in their share price than initially expected. Utilizing the Backsolve Method, which represents the current authority’s methodology recommendation after an arms’ length Preferred Stock Round, one can produce significantly different results depending upon the landscape of a Company’s capitalization table.

One Series B company observed had preferred shares representing 66% of the cap table. Under one set of conditions, the Common to Preferred Ratio calculated was about 40%. Take that same cap table, only decrease the Series B shares so the preferred shares only represent 61% of the cap table, and suddenly the Common to Preferred Ratio is just over 25%. This isn’t exactly a range where you can feel comfortable sticking your finger in the air with no company-specific analysis and expect it to stand before audit scrutiny.

Even within the same industry, each company’s cap table is uniquely structured. Boards will raise money at various pre-money valuations, at various times, with various preferences, and under various market conditions. With all the moving pieces affecting the value of common stock, resorting to an archaic measurement for Common Stock as a benchmark for whether the valuation is ‘correct’ undermines more reliable methodologies. And though the story of a valuation will always be an integral part of coming to the best answer, this particular myth cannot and should not be relied upon. If we are to learn anything from the disaster of Enron and the ensuing regulatory reform, it’s the importance of accurately valuing and accounting for company securities and stock compensation expenses. And like Bigfoot and the Yeti, it takes more than hearsay and a few blurry pictures in the woods to prove something reliable enough to be believed. Especially where the IRS is involved – they don’t seem to have a proclivity for tall tales.