When is the current value method appropriate?
Very early stage companies are allowed to use an asset-based approach to determine equity value. This approach is based on a premise that the company has not yet achieved a going-concern value, or goodwill. Likewise, equity value in early-stage companies may be allocated using the “current value method.” In most cases, this simply involves subtracting the preferred liquidation preference from the equity value. The residual, if any, is the value of the common stock. The combination of these approaches – the asset-based approach for valuing equity and the current value method for allocating equity value – tends to produce very low values for the common stock.
So when is this approach appropriate? According the to the AICPA Practice Aid1:
“Historically, the asset-based approach (using replacement cost) has been applied primarily to enterprises in Stage 1 and some enterprises in Stage 2. The asset-based approach would typically be applied under any of the following circumstances:
- There is a limited (or no) basis for using the income or market approaches. That is, there are no comparable market transactions, and the enterprise has virtually no financial history and consequently is unable to use past results to reasonably support a forecast of future results.
- The enterprise has not yet developed a product, although a patent application may be pending.
- A relatively small amount of cash has been invested.
“The use of the asset-based approach is generally less appropriate once an enterprise has generated significant intangibles and internal goodwill. The generation of these intangibles often starts to gain momentum in the middle stages of the enterprise's development and continues to build through the later stages.”
The Practice Aid defines Stage 1 and Stage 2 companies as follows:
- Enterprise has no product revenue to date and limited expense history, and typically an incomplete management team with an idea, plan, and possibly some initial product development. Typically, seed capital or first-round financing is provided during this stage by friends and family, angels, or venture capital firms focusing on early-stage enterprises, and the securities issued to those investors are occasionally in the form of common stock but are more commonly in the form of preferred stock.
- Enterprise has no product revenue but substantive expense history, as product development is under way and business challenges are thought to be understood. Typically, a second or third round of financing occurs during this stage. Typical investors are venture capital firms, which may provide additional management or board of directors’ expertise. The typical securities issued to those investors are in the form of preferred stock.
Characterizing a company as “Stage 1” or “Stage 2” is a judgment call, but the guidance provides a couple of criteria to consider. If the company is generating revenues, it has probably progressed beyond Stage 2. Likewise, if the company has closed more than three rounds of financing, it no longer qualifies. The definition of Stage 3 also helps in making the decision:
- Enterprise has made significant progress in product development; key development milestones have been met (for example, hiring of a management team); and development is near completion (for example, alpha and beta testing), but generally there is no product revenue. Typically, later rounds of financing occur during this stage. Typical investors are venture capital firms and strategic business partners. The typical securities issued to those investors are in the form of preferred stock.
A company with a nearly-complete product and a management team in place may no longer qualify for an asset-based approach to valuation.
Even if the asset-based approach is no longer appropriate for valuing the equity, there are limited circumstances in which it is still appropriate to allocate equity value using the current value method:
“Because the current-value method focuses on the present and is not forward-looking, the task force believes its usefulness is limited primarily to two types of circumstances. The first occurs when a liquidity event in the form of an acquisition or dissolution of the enterprise is imminent, and expectations about the future of the enterprise as a going concern are virtually irrelevant. The second occurs when an enterprise is at such an early stage of its development that (a) no material progress has been made on the enterprise's business plan, (b) no significant common equity value has been created in the business above the liquidation preference on the preferred shares, and (c) there is no reasonable basis for estimating the amount and timing of any such common equity value over the liquidation preference that might be created in the future. In situations in which the enterprise has progressed beyond that stage, the task force believes there are other allocation methods that are more appropriate.”
The second criterion is relevant to this discussion. Is the company as such an early stage that it has made no material progress on its business plan? To answer this question, it’s helpful to think of the elements common to most business plans:
- Develop a product or service
- Establish customer relationships
- Assemble the workforce and facilities necessary to produce the product or service.
Consider two examples, both of which are pre-revenue. Example 1 is a biopharmaceutical company in Phase 2 trials, working in partnership with a major pharmaceutical company. The company doesn’t have revenues or a product, but it has progressed beyond the stage when the current value method is appropriate. Example 2 is a newly-formed company which has received Series A financing to investigate a potentially promising group of compounds. In this instance, the current value method may be appropriate.
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1 AICPA Audit and Accounting Practice Aid Series. Valuation of Privately-Held-Company Equity Securities Issued as Compensation. 2004.