Valuation Articles

Why the Option Pricing Method trumps the Current Value Method

Tue, 01 Jul 2008 13:29:49 -0700

The Option Pricing Method has complicated the lives of valuation analysts industry-wide.

Most likely you, I and all of our peers for so many years have considered the Current Value (CV) method to be the tried-and-true standard of valuation. Sadly, this is no longer the case.

To level-set, the CV method takes the equity value of an entity, subtracts preferences and divides the result by the number of fully diluted shares outstanding to come up with a per share value of stock. Simple enough. But the FASB was unimpressed with the CV method. What they didn’t like was the fact that the CV calculation results in a negative share value if preferences are greater than equity value. As you probably know, an option by definition has a positive value. Thus came the irreverent exclamation from the FASB, “well, if all those options are worth zero (or less), then give them all to us.” Point made.

So by fiat the FASB and its practitioners caused the replacement of CV system-wide. This became known as Fair Value. Fair Value, purposes of valuing common stock, now relies on two alternative methods: 1] the Probability Weighted Expected Return Method (PWERM), and 2] the Option Pricing Method (OPM). While each has its place, the OPM is favored by practitioners because, frankly, it is simpler to audit.

Naturally, the OPM uses the Black-Scholes model to distribute the equity value across the capital structure -- in other words, to calculate the value of a common stock option. Mechanically speaking, this requires the valuation analyst to input share price, volatility, and several other variables to calculate the time-based value of the option. (Note that share price and volatility are highly sensitive inputs.) What happens when using the OPM is that the securities on the outer reaches of the capital structure take more value than the “reasonable man” standard -- that is, the CV method -- might suggest.

Now that Fair Value has taken hold, it is being enforced with teeth by the Big Four. What’s more, the IRS is apparently “leveraging the work of the Big Four” as they contemplate 409A compliance, according to at least one high-ranking IRS engineer. In other words, CV has been kicked to the curb.

Unfortunately, since the FASB discredited the CV method, we can no longer use it to backstop the value of the stock option found under OPM. In the end, stock options under OPM have more value (sometimes significantly more value) than under CV, and there's not a whole lot we can do about that.

In summary, there is a lot that goes into an option-based valuation report. It actually gets more complicated from here, including not only the mechanics of the OPM but also the Reverse OPM. But let’s leave that for another day.

FAS 157 reckoning in TheDeal.com

Mon, 21 Apr 2008 08:59:12 -0700

Today, at last, FAS 157 made its splash in the private equity scene as it was granted an appropriately-sized article in The Deal. As Dan Primack says (separately, in PE Hub), it's "the most important private equity issue that not enough of us are reporting on."

Our thoughts:

FASB 157 is here to stay, and PE firms are beginning to debate the merits of its implementation.

Recent volatility in the markets and controversies regarding valuation over illiquid investments have brought the issue to the forefront.

There is uncertainty over who will take on the new duties of developing the valuations and defending them in front of the audit community. Some firms are have created groups or positions internally, while others have gone to independent professionals. Regardless of what they do, it's a substantial commitment of time and effort.

Arcstone Rising

Wed, 09 Apr 2008 21:43:12 -0700

If you are a finance nerd, you’re in luck: valuation is enjoying a rising tide and, as our colleagues across the industry agree, finding good people that do good (valuation) work is no easy task. That's good for you. And we understand -- like you, we wanted a great job in a firm comprised of good people working in a growing industry. At Arcstone we got all that. And now we need more of us, which is where you come in.

If you think you might be a good fit for us, and vice versa, click on the download link above. Check it out, and be in touch.

Has 409A gone global? The FBT has expanded.

Fri, 11 Jan 2008 15:26:45 -0700

Recently we became aware of an issue in India that makes us think 409A is potentially going global. The Fringe Benefit Tax, or FBT has recently been expanded to include a provision for equity compensation, and it looks somewhat familiar.

It is our understanding that any company with employees in India compensated with stock options must report quarterly and pay a tax on the intrinsic value of an option as it vests. In addition, the valuation must now be performed by a Category 1 Merchant Banker registered with the Security and Exchange Board of India.

Two "relevant" valuation methodologies used in the FBT are the NAV and PECV methodologies. Briefly, the NAV (Net Asset Value) method is almost purely a measurement of net assets, which is obviously a poor measure for any growth stage company, particularly a venture-backed one. The Profit-Earning Capacity Value (PECV) method is equally mis-fit for a growth-stage company in that it extrapolates from after-tax earnings over the past three to five years. Clearly a non-starter for companies that do not have positive earnings in the first place.

With all this taken into consideration, we believe that the Category 1 merchant banks of India will be falling back on the widely accepted Fair Value standard, and others like it, for companies that are more difficult to value, such as venture backed startups and other growth-oriented companies. In fact, we have received such an indication already from at least one of our US-domiciled clients that has operations in India.

We are continuing our research on this issue, and will update this article as we learn more.

Please see the attached PDFs for more.

Valuation Updates: When and How

Thu, 13 Dec 2007 10:21:40 -0700

Yesterday we participated in a Fair Value forum with our friends and colleagues at Frank Rimerman, Grant Thornton, Trenwith, Cogent, FSCG and Perisho Tombor.

Among other issues, we discussed the common concerns of our clients relating to 409A/123R valuation practices. Our primary concern was how best to educate our clients and disseminate meaningful information relating to best practices. (Arcstone's humble attempt to solve this issue is the raison d'etre of these self-published articles you are reading now.) I was relieved to hear that the practitioners at the meeting were well aligned on some significant issues.

In general, the following practices seemed to be well accepted among the group:

Stock option grants should conform to a schedule. We recognize that sometimes special situations arise where a company cannot conform to a quarterly or semi-annual schedule, but best efforts should be made to keep grants to a regular timeline.

Boards should assess the magnitude of change since the last valuation. The rule of thumb that I am comfortable with is this: is the change in company status measurably significant? In other words, hiring a new VP of Sales is certainly significant, but we can't measure its impact quantitatively. However, if the new sales team really starts producing, we should be able to measure that both historically (beating expectations) and prospectively (increasing projections). If company management believes that the change is both significant and quantitatively measurable, perhaps it's time for a new valuation.

Regardless of the outcome of the above, carefully note that the discussion was had and a decision was made. If you are asked at a later date why your company got a valuation in 1Q07 and 3Q07, but not 2Q07 or 4Q07, you may want to have the minutes explain the decision making process.

When another valuation is required, do not settle for a summary "update". These go by different names -- "updates" or "bundles" -- but the idea is the same, and that is to conduct an analysis using the previous valuation as a basis for the current analysis. It's simply not best practice to do so. Each business appraisal should produce a stand-alone document that adheres to all of the relevant standards. It should not depend on past appraisals for its substance.

As always, if you have any questions about the above thoughts, please do not hesitate to contact us. We are always happy to speak about these issues, and very open to suggestions and comments.

FASB releases SFAS 141R

Fri, 07 Dec 2007 22:15:46 -0700

The Financial Accounting Standards Board (FASB) today released Statement No. 141 (revised 2007), Business Combinations. The revised Statement establishes principles and requirements for how the acquirer shall:

Recognize and measure acquired assets and assumed liabilities
Recognize and measure the acquired goodwill in the business combination, or a gain from a "bargain purchase"
Determine disclosures associated with financial statements

SFAS 141R replaces or supersedes:

Statement No. 141 (2001)
FIN No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method

SFAS 141R amends:

SFAS No. 109, Accounting for Income Taxes
SFAS 142, Goodwill and Other Intangible Assets, “to, among other things, provide guidance on the impairment testing of acquired research and development intangible assets and assets that the acquirer intends not to use.”

Application of SFAS 141R applies to business combinations “for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008.”

To read the full Statement No. 141R, click on the "download file" link in the header of this post.

Cooley explains the 409A compliance delay

Thu, 25 Oct 2007 19:34:08 -0700

Law firm Cooley Godward Kronish released a short article tonight that explains the "transition relief" offered by the IRS with respect to 409A compliance. It is a reminder how much of 409A is outside the realm of valuation. In fact, darn near all of it.

I was surprised when a good friend of mine in the VC community snipped, "Just like the government to waste our time worrying about 409A, when all they do is push it back." Is that really your understanding??

In the words of Cooley:

"...even though Notice 2007-86 extends the period in which you can amend your nonqualified deferred compensation plans to comply with Section 409A, you are still required (and have been since January 1, 2005) to operate... in reasonable, good faith compliance with Section 409A."

This just about sums it up

Tue, 23 Oct 2007 20:07:13 -0700

There's plenty of confusion out there. But it's starting to get easier as the various constituencies are absorbing industry best practices. It used to take me all of an hour to describe how the industry has been turned on its head by Fair Value accounting, and (more importantly) what to do about it. Today, it was a quick back-and-forth that took a grand total of four emails to sort it all out:

Client email: "I was hoping we could schedule a call with our auditor to discuss our valuation requirements."

My email: "We strongly believe that valuations should be dual-purpose; that is, conducted according to Fair Value standards to satisfy tax (IRC 409A) and GAAP (SFAS 123R) requirements."

Audit Partner's email: "I agree. We like to see a dual purpose valuation that meets the AICPA TPA guidelines using an option pricing model to allocate enterprise value to common stock (avoiding use of the current value/liquidation model). As long as that is what you're doing, then no need for a call."

My email: "That's exactly what we're doing. [Client,] I'll ring you shortly to discuss details."

That's progress in the form of efficiency.

Auctioning Options

Mon, 22 Oct 2007 21:34:33 -0700

David Reilly appeared on C2 of the WSJ today with an article on the SEC's final clearance for Zions Bancorp to use an auction process to value employee stock options. It's a novel approach that Zions will presumably take to market. Potentially a nice option for publicly traded companies to keep their FAS123R expense down.

But frankly, why go to all the trouble? Do analysts really factor in non-cash expenses such as the expensing of stock options on the income statement? Perhaps I'm naive, but I figured everyone would factor them out. Perhaps I am too taken with Martin Whitman's arguments against the primacy of the income statement.

The FAS 157 Train: an analogy that won’t stop

Fri, 19 Oct 2007 05:15:04 -0700

Catching up on some overdue summer reading, I picked up the June issue of the Venture Capital Journal (VCJ) to read about the latest from Tuck’s Center for Private Equity and Entrepreneurship. Some interesting trends jump out of a survey recently conducted by professors Blaydon and Wainwright, which are confirmed by Arcstone’s own anecdotal experience.

Boiled down, we continue to hear this subtitle to everyone’s assessment of FAS 157: “the train has left the station.” Indeed, so it appears to us as well. In the words of the VCJ, “the reality of FASB pronouncements and auditor pressure is making most GPs adopt” Fair Value portfolio valuations. Couple this auditor scrutiny with a drive among LPs for greater transparency and you get widespread GP compliance. That’s exactly with the Tuck numbers report.

Two issues highlighted in the Blaydon/Wainwright study are worth calling out:

A full 20% of respondents to the Tuck survey “provide their LPs with ‘side schedules’ that contain… valuation estimates that differ from audited financial statements.” Yet at Cooley’s Private Equity CFO conference in Beaver Creek this summer, we heard veteran auditors from one Big Four firm state clearly for the record that any VC or PE firm that produces such a side schedule would not receive an unqualified audit opinion. My guess is that next year this 20% figure will fall significantly.
Nearly 90% of respondents “did not use third party valuation services” to conduct or consult in the valuation of their funds. I’m not going to venture into self-serving territory here. But I will say that there are well-founded opinions on both sides of this one. If you happen to be in San Francisco on November 7, you may get a chance to see some sparks fly over this very topic, among others.

Join us

Overall, I’d say the VCJ article is a good, quick survey indicating what’s apparent to us anecdotally. FAS 157 is now being adopted by some of its staunchest detractors.

Venture Capital Journal, June 2007 issue.

Unité, Clarité, Fraternité?

Thu, 18 Oct 2007 10:10:28 -0700

David Reilly is on a FAS 157 tear. Appearing on the right column of C1 in yesterday’s Wall Street Journal, Mr. Reilly penned an article about the newly formed Center for Audit Quality, an industry group that has “emerged as the voice of the Big Four.” It’s a nice quick read, so look it up and digest it.

Apparently the move to create the CAG has been somewhat controversial – after all, who needs another standards-interpreting body? I’ll be the first to say “We do!” We have the FASB to establish the standards, and the SEC to enforce them. Yet the “first line of defense,” the audit firms themselves, have not always been in perfect accord. In fact, in our little sliver of the industry, we’ve found quite the opposite to be true. My personal opinion is that this is one situation where authoritative bodies with disparate interpretations of highly nuanced standards will benefit well from locking arms. It’s quite a murky world in here, after all. The more unity, the more clarity, the more certainty, the better!

See “With New, United Voice, Auditors Stand Ground On How to Treat Crunch”, Wall Street Journal, October 17, 2007, by David Reilly.

FASB votes not to delay FAS 157

Wed, 17 Oct 2007 14:59:41 -0700

During today's open meeting of the Financial Accounting Standards Board, the members discussed the application of FASB Statement No. 157, Fair Value Measurements and considered deferring the current effective date.

My partner Alex Hodgkin, who is in Connecticut today at the quarterly Appraisal Issues Task Force meeting, received word that the FASB voted 4 to 3 NOT to delay compliance with FAS 157, at least on a blanket basis. It looks like the effective date of November 15, 2007 will stand.

However, as David Reilly wrote in the WSJ following the announcement, the FASB did leave the door open "to defer... perhaps to private companies who follow generally accepted accounting principles."

Your projections matter. Now.

Mon, 24 Sep 2007 23:25:18 -0700

Here’s a couple of valuation truisms every CFO should know.

Valuations are often highly reliant on the forward-looking projections of the client,
Valuation reports are undergoing scrutiny in the financial reporting realm as never before. The same will likely be said about the tax realm when the IRS finally takes off its gloves and starts prosecuting.
This scrutiny will likely go beyond valuation methodologies and standards of value, and looks through the report to the underlying assumptions that the report is built upon, namely the company’s projections.

Here’s a singularly important conclusion that you can draw from the above: your projections matter. I don’t care how young your company is, or how cloudy the crystal ball. If you don’t have the time, capability or inclination to build yourself a nice, tight financial model that looks forward 3 years or more, then hire someone to go do it for you (rather, with you).

Think of it again, from another perspective. If you begin by building out decent financial projections now, you will have a coherent story to tell the SEC or IRS when it comes time to justify your expectations and option pricing history. Because hindsight is 20/20, it may tempt those scrutinizing your books to employ revisionist history to your detriment. Can’t you imagine someone saying, “you must have seen this M&A exit coming. So why didn’t you build that into your exit assumptions? Why wasn't this reflected in your stock option price?” You can see where that line of thinking may lead. So keep your model fresh, keep good notes in the margins, be true to the facts of your situation, and above all else keep it realistic. Finally, keep a history of your work because you may need it later.

By the way, if you need a recommendation for a good analyst to help you craft a decent financial model, we’d be happy to make an introduction. It is often an arduous exercise so you had better deal with this now, before you engage your valuation provider. It’s that important.

Extension of 409A Compliance: Why?

Mon, 10 Sep 2007 21:23:37 -0700

The IRS announced today that taxpayers will have until December 31, 2008, to comply with the 409A regulations, which were finalized in April of this year. The initial date of compliance was year-end 2007.

The questions I have are these:

Did the IRS cave to concerns from so many law firms fretting about not having enough time to achieve compliance? Quite possibly. We’ve heard some stories. Let's remember that a very large part of IRC 409A compliance lies outside the realm of valuation. Of the 300+ pages of the code, valuation comprises about three, while the rest is dedicated to comp plan design.
Alternatively, is the IRS still trying to figure out how to prosecute 409A valuation cases? Not likely; the case law applying to Fair Market Value appraisals is robust.
Or is the IRS having a hard time staffing up with sufficient qualified analysts? The last time we checked, the Monster board had more than 2000 open recs for valuation analysts.
Finally, is it possible that the IRS is itself concerned with the collision of 409A and SFAS 123(R) / SFAS 157? Again, quite possibly. Certainly more time is required to hash this one out. The Appraisal Issues Task Force, and others like it, has only begun to debate the far-reaching consequences of these colliding standards. The FASB has created the Valuation Resource Group to wrestle with this issue itself.

Extension of 409A Compliance: What's it mean?

Mon, 10 Sep 2007 19:33:29 -0700

The IRS announced today that taxpayers will have until December 31, 2008, to comply with the 409A regulations. The regs were finalized in April of this year, and had an initial compliance date of year-end 2007.

So what does this mean for privately held companies -- our clients and would-be clients? Short answer: not much.

The period for which companies are held accountable to 409A stretches back to December 31, 2004, so postponement does not mean you get to delay your attention to 409A. In fact, quite the contrary. The longer companies put off 409A-compliant valuations, the more valuations will have to be conducted retrospectively. Retrospective valuations can be time-intensive and costly.
Contemporaneous valuations are widely held to be significantly more defensible than retrospective valuations. To take full advantage of the safe harbors allowed by the IRS, you should get in compliance early, and stay in compliance.
The good news is that the mad rush for valuations (among procrastinators) has apparently been postponed. So, if you're not yet compliant, you can still beat the mad rush. Not a bad idea, considering the alternative is less robust and more expensive.