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Valuing Common Stock in Anticipation of a Biotech IPO

My article “Valuing Common Stock in Anticipation of a Biotech IPO” appeared in the May 2012 issue of Business Valuation Update, published by Business Valuation Resources. Here are a few takeaways: • The window for biotech IPOs is open. • A company’s venture investors are virtually required to invest in the IPO as well. It’s not a liquidity event for the VCs. It’s another financing. • The SEC requires the company to explain the difference between the estimated offering price and the strike price on its options. Stock options are an important form of compensation in venture-backed companies. Accounting guidance (ASC 718) requires the issuing company to record the expense associated with each option. The value of the option depends on its strike price relative to the value of the underlying security (common stock). Prior to a public offering, the value of common stock in a private company is an unknown. Nevertheless, with the help of appraisers, companies are ...

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Rules of Thumb

Is there a rule of thumb for valuing common stock relative to preferred?  If a new preferred round is priced at $1.00 per share, can we assume that the value of common is $0.10?  No.  By now, most managers of venture-backed companies understand that the old 10% rule is dead.  The AICPA Practice Aid (Valuation of Privately-Held-Company Equity Securities Issued as Compensation) states “The use of ‘rules of thumb’ is not (and never has been) an appropriate method for estimating the fair value of a company’s common stock.”  Nevertheless, many managers still want to get a sense of the common stock’s value before engaging a valuation specialist.  Once the draft appraisal is completed, managers often respond by saying it doesn’t “feel” right.  The guidance is the guidance, but that doesn’t prevent us from at least asking the question:  mathematically, is there a way we can reliably estimate the value of common r ...

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Pre-Money and Post-Money Confusion

Venture capitalists have a short-hand nomenclature for valuation that causes confusion for appraisers and their clients.  I’m referring to “pre-money” and “post-money” value.  Assume a company has 10 million common shares outstanding and it issues 5 million Series A convertible preferred shares priced at $1.00 each.  The pre-money value is equal to the product of the common shares outstanding times the Series A price (10,000,000 X $1.00 = $10,000,000).  The post-money value is equal to the pre-money value plus the proceeds from the issuance of Series A ($10,000,000 + $5,000,000 = $15,000,000). So what’s the problem?  It’s that the value of the equity isn’t really $10 million.  The VC pays $5 million for Series A shares with privileges the common stock doesn’t have.  For example, the Series A preferred is entitled to a liquidation preference over the common stock.  When we multiply the Series A price times all the ...

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Should We Value Intangibles? How?

Compare the balance sheets of three companies: Pacific Gas & Electric, Wal-Mart and Google.  You’ll find that the assets listed by PG&E and Wal-Mart provide a fairly accurate indicator of what these companies do.  Power plants account for more than two-thirds of PG&E’s assets.  Stores account for more than half of Wal-Mart’s assets, followed by inventory (20%).  Now take a look at Google.  Cash accounts for more than half its asset value.  Property and goodwill each provide for about ten percent of Google’s reported assets.  Is Google a bank?  Nowhere on its balance sheet does it list its proprietary technology, its customer base or its universally-recognized name. When we talk about valuing intangible assets, we’re not talking about assigning value to a will-o’-the-wisp.  Does anyone doubt that Google’s technology is valuable?  We need to value intangible assets because the economy has changed.  Ba ...

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Changes in the Value of Common Stock

One reason it’s difficult to value common stock in a venture-backed company is that the value of common is more volatile than the value of equity.  A small swing in equity value, up or down, can trigger a much bigger change in the value of common.  If we’re valuing equity based on market multiples, which change every day, the value of common is likely to bounce around. The volatility is the result of financial leverage, the same phenomenon which contributes to higher earnings and losses in companies financed with debt.  Unless equity value is high enough to trigger conversion of preferred, the preferred liquidation preference is like debt.  Equity value may increase by a small amount, but if it all flows to common with none to preferred, the effect on common value can be dramatic.  To illustrate, assume a venture-backed company is capitalized with 1,000,000 preferred shares and 500,000 common shares.  The preferred liquidation preference is $10 per share, so the pr ...

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Best Practices for Contributory Asset Charges

The Appraisal Foundation has released the first of its “best practices” guides for valuations in financial reporting.  This one addresses the issue of contributory asset charges and is available on The Appraisal Foundation’s website: https://appraisalfoundation.sharefile.com/d/s80f9c7da9e744de9 This monograph, named “The Identification of Contributory Assets and Calculation of Economic Rents” is the work of a committee established by the Appraisal Issues Task Force (AITF).  The AITF has other committees at work which will be releasing guidance on additional topics related to valuations in financial reporting.  The goal of this effort is to reduce “diversity in practice.” Valuing intangible assets for financial reporting is a tricky business.  Hire two well-qualified appraisers to value the same collection of assets, and it’s likely they will come up with different values.  Some diversity is unavoidable.  Valuation, after al ...

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