New Auditor May Not Like This 409A Valuation Trick

Frequently, startups find it desirable to make stock options cheaper for their employees to exercise.  The exercise price, amount an optionee would pay to take ownership of a share of common stock, is commonly set based on the fair market value of the common stock at the time of the grant.  Hence, the need for 409A valuation that estimates that value.

Despite various pitfalls, the pressure to justify lower valuations with creative valuation methods and inputs persist.  There are many interesting theories that challenge current best practices (memorialized in AICPA Price Aid) and advance our understanding of the valuation science.  Yet, others are clearly incorrect and would not withstand careful third-party scrutiny.  A reputable financial audit firm is often the first to mounts consequential challenge to inadequate 409A valuation.

OPM Backsolve

One erroneous methodology can be found in 409A valuations prepared following a fresh financing round.  Best practices commonly require a valuation to be performed with Option Pricing Model (“OPM”) backsolve method.  The OPM links new issue price of the preferred stock with the value of the common stock.  The backsolve is the process of calibrating the OPM such that the value of the new preferred round within the model and its issue price are the same.  The calibrated OPM will also produce the common stock value.

OPM backsolve is straight forward, but also rigid and unsympathetic to management’s inputs.  The key inputs are limited to guideline public company volatility and time to strategic exit.  The effects of volatility and term are mostly blunted by the discount for lack of marketability (“DLOM”).  For example, lower volatility will decrease both pre-DLOM common stock value (output of the OPM) and the DLOM itself, thus minimizing the impact from the key factors.

OPM Backsolve Plus Failure Scenario

To escape the iron grip of the OPM backsolve method, 409A valuations frequently use inadequate scenario analysis.  It works like this:

  1. OPM backsolve calculates the value of the common.
  2. Another scenario is introduced where the company is expected to exit without producing any value to the common stock, or a Failure Scenario. This is the problem step.
  3. The common stock value is calculated as a weighted average of both scenarios.

Fundamentally incorrect, this approach is near guaranteed to be rejected by a reputable financial auditor, leaving the client with a paper trail suggesting that the exercise price established by the Board might not have been adequate.

It is incorrect to introduce an additional failure scenario because the OPM calculation already takes into consideration all possible outcomes (however, there are questions as to whether OPM gives failures enough weighting).

Secondly, if we calculate the value of the common based on two scenarios, we should also calculate the value of the new preferred stock based on the same two scenarios.  Because the OPM backsolve has been calibrated to the new preferred issue price, an additional failure scenario would imply the value of the new preferred to be less than its issue price.  In most cases, neither valuation specialist nor management can credibly argue that investors overpaid.

OPM Backsolve Criticism

There is no shortage of criticism of the OPM backsolve.  For OPM to work properly, company future valuation opportunities must be lognormally distributed; they are certainly not.  Companies will have to raise a lot more funds before they exit, thus current liquidation preferences are rather irrelevant.  OPM does not capture many important economic and none of the legal rights of the preferred shares.  It often breaks down in many down-round financings.

Unfortunately, instead of improving OPM Backsolve, the Failure Scenario introduces an arbitrary adjustment that contradicts the basic assumption of fair value financing.

Other Methods

Valuation firms used other methods to manage OPM backsolve:

  1. Building a parallel traditional valuation instead of the simplistic failure scenario. This approach is often rejected because it is completely subjective while still failing to reconcile to the preferred share issue price.
  2. It is possible to use a different term to exit in the OPM and DLOM calculations. AICPA Practice Aid illustrates how different exit scenarios may lead to such a situation.  This approach is more likely to be supportable.
  3. Replacing OPM backsolve with scenario analysis (Probability Weighted Expected Return Method or PWERM). While not always the best practice, this method can reconcile to the preferred issue price.  This analysis is more expensive, so leave your bargain-hunter hat at the door.
  4. In certain situations, the OPM backsolve may not be correct, e.g. when the latest round is senior but without control.

Scenario analysis is intuitive initially, but often complex to implement.  While necessary in some situations, it should be treated carefully when a company does not anticipate near-term exit.  Our final recommendation for management to have a clear understanding of how and why a 409A valuation would use scenarios and whether it supports the purchase price of the recent equity round.

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