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Squaring Venture Capital Valuations with Reality

papers.ssrn.com

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Re: Squaring Venture Capital Valuations with Reality

#11

Post by stanleydrew »

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options as $6 in the money. Our approach shows the “fair” common share price was actually closer to $5.62, so these options were significantly out of the money.

Seems like this paper could provide a new 409a-compliant valuation method for common stock which might help to price employee options a bit better for these later-stage companies.

Re: Squaring Venture Capital Valuations with Reality

#13

Post by pge »

stanleydrew wrote: post #11

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options…

Existing 409A valuations already take all of that into account. When an employee is issued options, the one thing he can be reasonably sure of is that they are not in the money. Options have to be issued at or above the FMV for common stock, or it is taxable compensation to the employee. Note the "at or above" language. An employee's option has to be out of the money the day it is issued, but that could be by .01 or many dollars. The Board almost always has a valuation report done by a third party that values each class of stock separately, taking into account the various preferences and so forth. All of that is taken into account when assigning a value to the common options being issued.

Re: Squaring Venture Capital Valuations with Reality

#14

Post by markeroon »

zitterbewegung wrote: post #12

Reminds me of @dhh [1] except with causation. The example he used was Facebook but I think the oncoming adtech implosion might prove him right . [1] https://signalvnoise.com/posts/2585-facebook-is-not-worth-33...

Given that Facebook is now worth $500B, this seems like a weird article to post.

Re: Squaring Venture Capital Valuations with Reality

#16

Post by indescions_2017 »

Of equal interest is author's other paper entitled "How Do Venture Capitalist's Make Decisions?" And after 900+ interviews it's neither jockey nor horse nor any other correlation, but spray and pray all around.

Am currently negotiating a small ($10k) angel investment in an ecommerce startup in Indonesia. All "go" signals are there: ambitious team, growing market, outside foreign investment, etc. But as far as calculating a probability for any IRR? 50% it goes to zero, 50% chance 10x or better return, is as good as any model for the risks faced at early stage.

So what was the data point that finally tipped the scale for me to pull the trigger? The fact that in Jakarta you can hire a fresh, world-class engineering graduate for $500 a month to come work for you!

Re: Squaring Venture Capital Valuations with Reality

#17

Post by jogjayr »

pge wrote: post #13
stanleydrew wrote: post #11

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options…

Existing 409A valuations already take all of that into account. When an employee is issued options, the one thing he can be reasonably sure of is that they are not in the money. Options have to be issued at or above the FMV for common stock, or it is taxable compensation to the employee. Note the "at or above" language. An employee's option has to be out of the money the day it is issued, but that could be by .01 or…

Correct me if I'm wrong but the relevant 409A valuation is the most recent one done when you exercise your options and taxes on them become due. I think that's the situation GP was referring to, that this approach might help fix.

Unless you're saying that when Square's valuation suggested a share price of ~$15, a 409A done at the same time would have returned a value closer to the ~$5 that the paper suggests is more reflective of the average employee's situation.

Re: Squaring Venture Capital Valuations with Reality

#18

Post by indescions_2017 »

pge wrote: post #13
stanleydrew wrote: post #11

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options…

Existing 409A valuations already take all of that into account. When an employee is issued options, the one thing he can be reasonably sure of is that they are not in the money. Options have to be issued at or above the FMV for common stock, or it is taxable compensation to the employee. Note the "at or above" language. An employee's option has to be out of the money the day it is issued, but that could be by .01 or…

In reality perhaps options can be very much ITM when considering private sales or on secondary markets, if allowed by the granting startup. Even considering recent funding rounds and accelerating valuations. Lyft, for example, in its recent run since the Uber woes, may trade at a premium with plenty more upside in the coming months.

Re: Squaring Venture Capital Valuations with Reality

#20

Post by stanleydrew »

pge wrote: post #13
stanleydrew wrote: post #11

The rank and file employees of VC-backed companies often receive much of their pay as stock options. The naiive approach, likely used by many of employees, would dramatically overvalue their wealth. For example, the stock options Square issued around the time of its 2014 funding round had a strike price of $9.11.4 The naiive approach would take Square’s 2014 financing round at $15.46 per share and view these options…

Existing 409A valuations already take all of that into account. When an employee is issued options, the one thing he can be reasonably sure of is that they are not in the money. Options have to be issued at or above the FMV for common stock, or it is taxable compensation to the employee. Note the "at or above" language. An employee's option has to be out of the money the day it is issued, but that could be by .01 or…

The 409a sets the FMV. That's the whole point of getting it done.

So the logic is circular. Yes, any options issued with a strike price at FMV are "by definition" not in the money at time of issuance. But I can tell you from multiple experiences soliciting 409a valuations that the FMV of common is incredibly debatable, and is often essentially just negotiated between the founders/board and the valuation firm to be as low as possible (for the benefit of employee exercise).

The valuation firms are absolutely not always taking all differences between classes of shares into account. My comment was hoping maybe this paper would provide a method that we can all agree should be used for valuation of common stock.

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