A number of Teknos client companies complete an IPO every year and we thought that it would be worthwhile to share the best practices that we have developed in response to valuation questions from audit firms and the Securities and Exchange Commission (SEC) during the IPO process.
These best practices can be summarized as:
- Change the timetable for valuation reports;
- Change the allocation method; and
- Don’t change the comparable companies and other factors.
Change the Timetable for Valuation Reports
It is well known that IRC §409A requires a private company to obtain an independent valuation in order to issue stock options within a regulatory safe harbor and avoid penalty taxes on the option recipients.* According to IRC §409A, a company may rely on such a valuation report for 12 months from the valuation date, unless there is a material change sooner than that.
Most of our early and middle stage client companies obtain a valuation report from Teknos at 12 month intervals (unless there is a material change, typically a new equity financing). However, when a company begins to think about an IPO, this timetable needs to change, as does the rationale for obtaining the valuation reports. Whereas in the early years of a company’s life, the rationale may be primarily tax compliance with IRC §409A, in later years the rationale should be more about GAAP compliance with ASC 718.
We recommend that our pre-IPO client companies obtain valuation reports at least every six months when they are about two years away from an IPO filing and at least every three months when they are 12 to 18 months away from an IPO filing. It has been our experience that the sorts of events which can appreciably change the value of a company occur more frequently as the company grows larger and more frequent valuation reports are needed to capture the effect of these. Also, the SEC expects a pre-IPO company to report financial results on a quarterly basis during the 12 months before the IPO and quarterly common stock prices are necessary for accurate calculation of compensation expense in these quarters.
We also tell our pre-IPO client companies that they should use only a “fresh” valuation report when issuing stock options in the year before an IPO. That means they should use a valuation report which was prepared recently, typically no more than one month earlier, not three or even six months earlier. Again, this is because of the speed with which value can change at a late stage company – and because of the expressed preferences of audit firms and the SEC.
In a hypothetical example for a company with a quarter ending September 30, Teknos can prepare parts of a valuation report before the quarter end, insert the quarterly financial results as soon as they are available, and have the report ready for the board of directors to use before the end of October (we strongly recommend that the report not be used for other grants later in the quarter). This requires that a company limit itself to issuing stock options only once a quarter, but is well worth the effort because of fewer questions from audit firms and the SEC about the relevance of a “stale” valuation report to an option grant late in a quarter.
Change the Allocation Methodology
A standard valuation report really consists of two main parts: a valuation analysis (estimating the value of the enterprise, whether by discounted cash flow or comparison to public companies, etc.); and an allocation analysis (attributing the value of the enterprise to the various classes of securities, whether preferred stock, common stock, stock options, etc.).
The second part, allocation, generally must be a dynamic – not static – analysis. It would be easy to simply estimate whether shares of preferred stock and stock options are “in the money” and therefore whether they will be converted or exercised today at a given value for the company. By subtracting the liquidation preferences and dividing the remainder by the number of outstanding shares it is possible to easily calculate a per share value of common stock. But this is not a complete analysis nor is it acceptable under the guidelines of the AICPA accounting and valuation guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation (Valuation Guide). This current value method (CVM) fails because it does not allow for future changes – especially appreciation – in the value of the company and, by implication, of the common stock.
The two allocation methods which do take into account the potential for future changes in value are: the option-pricing method (OPM) and the probability-weighted expected return method (PWERM). The first, typically implemented with a Black-Scholes model, is used for most early and middle stage companies, when management cannot yet predict the timing or method of exit. The latter, typically implemented with a multi-branch scenario analysis, is used for many late stage companies, when management can predict the timing and method of exit, especially if that exit is an IPO.
Teknos utilizes an OPM for most of our client companies until company management begins to plan for an IPO. Then, in consultation with the company’s audit firm, we typically switch to a PWERM sometime in the 12 months before the earliest planned IPO filing date.
A PWERM requires more work than an OPM, for both management of the client company and the valuation firm, because it involves forecasting dates on which it would be possible to complete an IPO and other alternatives (e.g. completing a sale or remaining private) and assigning probabilities to each of these (e.g. 30% on an IPO in 12 months, 30% on an IPO in 18 months, 20% on a sale in 18 months, and 20% on remaining private). A PWERM also will attribute more value to common stock than will an OPM (because the effect of the liquidation preferences will be removed by automatic conversion in the scenarios which forecast an IPO) and this will cause the value of the common stock to rise slightly, even if every other factor in the valuation analysis remains the same.
Don’t Change the Comparable Companies and Other Factors
Whereas there are strong expectations that the frequency of valuation reports and the allocation method will change during the period before an IPO, there is an equally strong set of expectations that other elements of the valuation analysis will not change or will change only gradually during the same period.
One of the most significant factors which is expected to remain stable is the group of publicly traded companies. Additions for recent IPOs or subtractions for acquisitions are understandable, but other changes will be closely scrutinized.** On the other hand, the multiples selected from the group of comparable companies are expected to increase as the company approaches its IPO filing date (based on the assumption that if a company is good enough to complete an IPO it is going to be as good as at least some of the comparable companies).
The audit firms and the SEC also scrutinize the discount rate used in any discounted cash flow analysis (and in the discounting of PWERM scenarios); they expect it to shrink gradually over time. The same for the discount for lack of marketability (DLOM); it also is expected to shrink as the IPO date draws closer (sometimes the DLOM is expected to shrink faster than the put-option model might suggest).
We pay attention to secondary market transactions in the stock of the pre-IPO company during this period, as directed by the Valuation Guide. However, these may not be the most reliable source of valuation information. For example, there was a considerable amount of press attention paid to secondary market trading in the common stock of Facebook before its IPO: Fortune reported that there were transactions between $42 and $44 per share in April 2012; the IPO was priced in May 2012 at $38 per share; the price subsequently fell to $27 per share a week later and $17 per share in September 2012.
A company which has routinely obtained valuation reports in its early and middle stages of life will be in the best position to deal with valuation questions as it moves into the late stage, whether the process culminates in an IPO or a sale. In preparing for an IPO, remember to increase the frequency of the valuation reports from once a year to once a quarter, use only a “fresh” valuation report for option grants, have the valuation firm change the allocation method to a PWERM, and avoid big changes to the comparable companies, discount rate, DLOM, or other factors. With an experienced valuation firm following these best practices, there should be no show stoppers or even difficult questions about valuation during the IPO process.
*According to the provisions of IRC §409A, a company must either (a) obtain an independent appraisal, (b) use a formula pricing method, or (c) prepare an internal valuation report to move into the regulatory safe harbor and avoid the 20% federal surtax (plus an additional 5% surtax for California residents).
**One exception, however, is when the investment banks selected to manage the IPO have different comparable companies which they plan to use in pricing the IPO. Because Teknos has staff with a background in investment banking, we usually have anticipated these requests and supplemented the comparable company list before the banks are chosen.
Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.
Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services. However, nothing in this communication may be taken to represent the official position or policy of the IRS. The opinions expressed herein are those only of Teknos Associates.
IRS Circular 230 Disclaimer: Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.