Common models used to value a company, how these apply to startups, stock valuation, stock option valuation, and comparisons with US GAAP accounting valuation.
Common Company Valuation Methods
Market Capitalization
Most people are familiar with terms like “market cap” if they have any interest in publicly traded stocks. Market capitalization is a method that can be used to value a company by taking the number of shares of stock issued and outstanding times the current stock price listed on whatever exchange they are traded on (e.g., Microsoft trading at $30/share X 8.39 Billion Shares Outstanding = $251 Billion Market Cap). The problem with this method is that it varies so widely based simply on the free market’s trading and can be easily affected by institutional investors and brokers buying and selling in large blocks at certain times of the month, quarter, etc. Just because the market is willing to pay $30 per share for a share of stock, that is only an indicator of what the fair market value is of that share of stock. This can sometimes be based upon speculation, recent news, or other factors that really don’t accurately tell someone what the actual business is worth. The biggest problem for startups or small emerging growth companies is that they are almost always private and do not have a fair market value for their stock to use for this calculation. You can look to recent private sales of stock to show what those investors were willing to pay, but that is not a predictor of what the market, in general, may pay for the stock. This is why it is hard to predict exactly where an IPO per share price will end up after the stock starts trading and settles into a trading range.
Book Value
Another method is to look at what the company’s book value is, i.e. what does the company’s balance sheet show for its assets minus its liabilities (which is the same as owner’s equity). The difficulty in this method is that it is looking simply at almost a liquidation type of scenario and doesn’t take into account things like future business deals, revenue growth, and other aspects of a business. The main difference from liquidation value is that it uses the booked amount of value for an asset versus the current fair market value of that asset. It also relies upon the company’s accounting records being accurate and using proper ways to record the value of certain assets and debts, such as the wild variations in how certain intellectual property value might be shown. For example, trade secrets, business methods and business contracts are often not booked as an asset, but clearly hold value for a business or a patent could be booked based upon the cost to acquire or apply for the patent, which doesn’t always show the true value of the patent.
Discounted Cash Flows
A traditional and common finance valuation method is discounted cash flows, where you are looking at the current value of future cash coming into the business. The reason it is “discounted” traditionally is because cash in the future has a different value than cash right now and there are issues of risk and projected rate of return, so it adjusts future cash and comes up with the current value of that future cash. Traditional time frames used for the cash flow calculation vary but are usually in the several year time frame (3 to 5). You could also use a similar free cash flow to equity calculation which is the current value of cash available (using discounted cash flow calculations) to pay to equity holders less the costs of paying off debts.
Enterprise Value
Enterprise value takes a modified form of market cap to adjust for the company’s debt. It is most commonly thought of as what are the total costs to acquire the entire enterprise, i.e. purchase its stock, pay off its debts, etc. This might calculate acquisition costs, but it doesn’t tell the investor what their stock would be worth since it includes debt.
So what is the best valuation method, there is no one right answer. For a new company, the investor generally wants to know what their investment will be worth in a certain time frame. You can show things like comparisons and analysis to other companies in a similar industry as a basis for calculations. You would need to find public companies in the same industry to find information like price-to-earnings multiples or other common valuation metrics. In the end, you need to look at projected cash flow and how that will translate into an increased investment for the investor. If the company already has revenue, it can show things based upon prior earnings and projected growth of those earnings, but most startups need to simply rely upon their own projected value method since they are pre-rev. The key when raising money is to understand that the way you value your company could vary widely from what an investor thinks is the best way. You need to be sure to document the assumptions that are the basis for your valuation calculation and compare different scenarios so that when an investor asks you what would happen if X or Y happens, you have a way of explaining how different variables would affect your business’ bottom line and their eventual investment.
Stock Option Valuation
Many people want to know what the stock options they got or may get with a company are worth. Again, there are different methods to determine value, but they usually involve the current fair market value of the underlying stock issued upon exercise. (A stock option grant is a contractual right to purchase a number of shares at a set price and to “exercise” this right means you are purchasing a certain portion or all of the stock grant). The traditional method now used by most companies is called the Black-Scholes Option Price calculation, although some companies use what is called the binomial model. It is a somewhat complex calculation and is used to assign a value to the stock options that needs to be recognized by the company as compensation expense for accounting purposes. For an employee, they are not as concerned with how the company accounts for the option, but what it is worth to them now. The company needs to keep track of these things for tax purposes and securities law compliance since a certain level of option grants can result in securities law reporting issues. You can find lots of online calculators that will calculate this for you.
The easiest way for an employee to think of the value of the grant is to compare the fair market value of the stock with the exercise price listed in the grant. For example, if the stock is worth $10 per share and the person was granted the right to purchase the stock at $1 per share, the value of an option grant would be $9 per share times the number of shares in the option grant. The obvious problem for a startup or other small company is how to determine the fair market value of the stock or what the stock might be worth in the future. There is no right answer unfortunately. You really have to use your best judgment and look at things like what the most recent investors were willing to pay per share or other company valuations to see what it may be worth. Also, you have to think about the company’s future growth as this will raise the value of the stock, and, in turn the value of the stock option grant. There are also issues of whether you can easily sell the stock once you exercise your option and get the stock. There are often legal restrictions on the ability to sell stock and often little to no market exists to but the stock from you. If the company goes public or gets acquired, you will usually have a way to sell the stock within those transactions more easily, but you have to exercise your option by paying the exercise price to get the stock first.
The bottom line for founders or other people getting involved with a startup or other emerging growth company, think about what your time is worth and if you are taking less than your normal hourly market rate, does the stock grant or stock option grant adequately compensate for that difference. You also need to think about the opportunity cost of putting your time and effort into a company when you could be working for just cash or for another company. There are risks that you might not realize any value from the option (company goes bankrupt, no public market to sell the stock, or you are restricted from selling it for 90 days, a year, or more). You also have to come up with the cash to exercise the grant unless the company is willing to do a net issue exercise (also called a cashless exercise), which means the number of shares goes down to adjust for the fact that you are not putting in the exercise price in cash.
The main things to look at in an option are:
- Current fair market of the company’s stock & projected future growth of the company’s stock
- Exercise price, as compared to current or future price of the stock
- Number of shares
- Vesting schedule- you only gain the contractual right to exercise the option after the stock has “vested”, so most grants vest over a period of time to insure the employee stays with the company long term
- Maturity, duration, or termination- A stock option right is not granted forever. There will be a limit on when you can exercise the option and if you fail to do so in that time frame, you lose the right to that option grant. Employees should also look to see what happens if they are terminated from or quit their employment. Many option plans state that a terminated employee has a short period of time to exercise their option rights or they lose them (in some cases 30, 60, or 90 days).
- Tax issues- This section is too general to get into the specifics of tax consequences, but the employee should look into what effect the option grant, exercise, and eventual sale has on their personal taxes. They also need to see if the option qualifies as an incentive stock option (ISO) or non-qualified stock option (NSO), as that can make a difference in tax consequences.
Additional discussion of stock options is also included in the section on Compensation.
US GAAP Accounting
There are a set of standards used by the accounting and finance community for how to deal with valuation and other value issues. The company needs to keep their books according to the standards and rules set out in the U.S. generally accepted accounting principles (US GAAP) for a variety of reasons, especially for a future IPO or tax reasons. These strict rules set out the way a company keeps its books and can have differing rules for recognizing revenue, valuing a patent, or other items. You need to understand that US GAAP accounting may show a value for something like a stock option or patent application that is wildly different than what it may actually be worth to someone. When dealing with valuation of a company, US GAAP does not have to be used in most cases, but a basic understanding on how it may be different can be helpful. When you read publicly traded company financial statements, most sections will be prepared according to US GAAP and any exceptions will usually be explained, disclosed, or listed in the footnotes to the financial statements.
Sometimes US GAAP can affect employees. For example, the financial accounting statement number 123 (FAS 123) promulgated by the financial accounting standards board (FASB) was changed within the last few years to allow for better tax treatment in dealing with exercise of stock options and can affect whether a company may want to allow net issue exercises.
IP Valuation
One major problem for tech companies, especially those dealing with new technologies or developments is how to value the intellectual property of the company. There are ways of valuation for conservative accounting purposes, but the new company often wants to find ways to show higher value in order to raise money. There are three main methods of valuation: i) Market Approach- looks to the market and compares your product or service with something similar to come up with ideas on what your idea is worth, ii) Cost Approach- what did it cost to acquire or develop the IP, in other words, what would it cost to replace or reproduce it, and iii) Income Approach- this estimates the future benefit of the IP. Often the income approach is more speculative, but tends to lead to higher valuations, but only for income producing IP. So if you predict that a patent will lead to a marketable product, what will be the future revenue from that product and what is that worth now. However, this approach may not work if an item of IP, such as a trade secret or business method may not be tied directly to revenue. The common forms of the income method you may hear about are relief from royalty (how much would the company pay in royalties if it used, e.g. licensed the technology from someone else), Greefield (this uses traditional discounted cash flows to estimate future cash flows from only the IP), excess earnings (what amount of additional excess cash would be generated by the IP), or lost profits (difference between profits with the IP versus profits without the IP).
There are many forms of valuation, and the specific application will determine which method may work best. Obviously, most startup or emerging growth companies want a high valuation, but the key to handling investor questions is to thoroughly work through the best methodology and be able to explain the underlying assumptions of how you ended up with your current valuation. If all of this discussion sounds completely foreign, find a good finance person to help you, such as an interim CFO, even if it is simply to prepare financial projections or valuations.
If you have questions regarding the above, please reach out to Chris Barsness at cbarsness@patellegal.com.