There Is A Reason Why Preferred Equity is Called Preferred:
Preferred Equity’s Big Impact on the Value of Common Stock

The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for tax and accounting compliance. But more importantly, they determine the amount of money shareholders will receive when the long hoped-for “exit” is finally realized.

This is the second in a series of posts meant to help explain many of the typical terms for preferred equity we see in our daily valuation work. Hopefully, this analysis will provide some guidance on the impact to the holders of common shares. (There can be legal issues which also come into play, especially in contested matters. However, this blog is not legal advice, and the specific facts and circumstances for any particular case will differ from the examples described herein).

Seniority: Preferred Equity Is In-Between Debt and Common Stock at M&A Exit

The preferred stockholder’s liquidation preference (together with the degree of participation) is a key factor is determining how much, if anything, common stockholders receive in an M&A exit. Participation will be the subject of subsequent blogs.

Most of the companies we see are early stage venture capital backed technology companies. They typically have a capital structure comprised of common stock, preferred stock, and occasionally debt. The exit for an investor is sometimes an IPO, but more frequently, it is a “liquidating event”, which can mean either the company is sold in an M&A exit or the company is shut down. In the case of a liquidating event, the seniority of each component of the capital structure becomes key to whether and how much of the liquidation value is received by each class of shareholder. Take, for example, a company that was funded by $20 million in preferred stock and $5 million in debt. The debt is considered to have first priority on the proceeds available for distribution from the liquidating event, typically the preferred equity has second priority on the proceeds (due to its liquidation preferences), and the common equity has whatever is left over (in this case, it stands third in line). If the company is sold for less than $25 million dollars, the debt holders would get paid off first, the preferred equity holders would get the rest (but not their entire preference amount), and the common stock holders would get nothing. The common stockholders would only receive a distribution if the company is sold for more than $25 million.

Liquidation Preference Multiple (1x vs. 2x) and Similar Provisions

In many cases, the liquidation preference is “1x”, which means the preferred equity gets one times the amount they invested. In the example above, the preferred equity put in $20 million, so the amount of their liquidation preference is $20 million.

However, a liquidation preference can be “2x” (or “3x” or some other multiple), meaning the preferred equity gets back twice the amount invested before any proceeds are distributed to common stockholders. In the example above, the preferred equity would get back $40 million.

In some cases, there may be a mandatory dividend on the preferred, or the liquidation preference is structured so that the amount of the liquidation preference grows at a specified rate (e.g., 8% per year non-compounding) until the exit event. In the above case, assuming a three-year term to exit, the liquidation preference for the preferred equity would be $24.8 million. The key point is that liquidation preferences greater than 1x mean that the common stock holder receives nothing until and unless the preferred equity holder receives a return of capital plus a specified amount of profit.

Conclusion

Liquidation preferences provide preferred shareholders with downside protection on their investment. In some cases, liquidation preferences also provide for a profit. Of course, the assurance is not absolute. At an exit, legally enforceable obligations (such as debts, lease commitments, legal judgments, etc.) must be satisfied first. However, once these first priority claims are satisfied, then the preferred stockholder is second in line and ahead of the common stockholder.

The preferences of preferred stockholders do not end with just the liquidation preference. In the next blog, I will describe what happens after the preferred stockholders receive the liquidation preference in an M&A exit through their participation rights.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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There Is A Reason Why Preferred Equity is Called Preferred:
Preferred Equity Has a Big Impact on the Value of Common Stock

The terms and conditions on preferred equity frequently issued to venture capitalists may seem arcane, but the impact on the value of common stock (and stock options) is significant! These impacts are important for 409A compliance. But more importantly, they determine the amount of money employees may receive when the long hoped-for “exit” is finally realized.

This is the first in a series of posts meant to help explain many of the typical forms of preferred equity we see. We will provide guidance on the impact to the holders of common shares.

Preferred equity is extremely malleable, the specific terms and conditions are tailored to the facts and circumstances of each unique case. So there can be additional differences between the cases discussed here and the specific equity structure of any particular company.

Overview of Preferred Equity

Preferred equity is sometimes described as a hybrid security that combines elements of a debt security and an equity security. To the extent that the preferred equity provides for the return of principal and commits to the payment of dividends (in effect the dividend acts like an interest payment), it is similar to debt. To the extent that there may be no specific time-frame for when the original amount invested must be repaid and it participates in the growth of the company, it is similar to equity.

Venture Capital Preferred Equity is Different

In venture capital financings, the debt-like characteristics of preferred equity are changed and significantly expanded. While often there is no mandatory dividend, there are hosts of additional rights, protections, and privileges. Preferred equity issued to a venture capital firm is a highly customized security that provides the preferred investor a set of provisions (“preferences”) that are tailored to each company’s unique requirements and circumstances. Preferred stock rights often grant the preferred stockholder advantages relative to the common stockholder. The preferred equityholders may have some or all of the following rights:

o To earn a return on their investment that is disproportionate to the percentage of shares owned relative to the common,

o Downside protection, and

o To have disproportionate influence or control over the company.

Economic Rights and Control Rights

Using the terminology of the AICPA, certain provisions give the preferred equityholder economic rights and control rights: “…preferred stock has characteristics that allow preferred stockholders to exercise various economic and control rights”.[1]

Economic Rights

o Preferred Dividends – As discussed above, mandatory dividends are infrequent in the venture capital transactions we have observed. However, specific dividend rights may be granted.

o Liquidation Distributions – These rights are critical to understanding the value of common shares. These rights refer to the specific rules by which the proceeds from a sale of the company are distributed among each class of shareholders.

o Mandatory Redemption Rights – These rights give a class of preferred equity the ability to require the company to buy back the preferred shares (exit the investment) before the ultimate liquidity event.

o Conversion Rights – These rights give a class of preferred equity the ability to convert their shares into common stock at a specified conversion rate. While most conversion rates are 1:1 (one share of preferred stock is exchangeable into one share of common), we sometimes see different conversions rates such as 1:2 (one share of preferred stock is exchangeable into two shares of common). Frequently, preferred shares are subject to mandatory conversion (they must be exchanged for common shares) if the company proceeds with an IPO.

o Anti-dilution Rights – These rights give a class of preferred equity the ability to adjust liquidation and conversion rights so that dilution is either reduced or avoided due to the issuance of new shares.

o Registration Rights – These rights give a class of preferred equity the ability to compel the company to use its best efforts to proceed with an IPO (or secondary offering).

Control Rights

o Voting Rights, Drag-Along Rights, Protective Provisions, and Veto Rights. These rights give a class of preferred equity disproportionate voting or veto power over the company, or the right to compel other equity classes to vote a particular way.

o Board Composition Rights. These rights give a class of preferred equity disproportionate power to designate specific board members, or to control the board.

o Management and Information Rights. These rights give a class of preferred equity access to pre-specified information such as financial reports, company plans, and the right to attend and observe board meetings.

o Participation Rights (Future Financings). These rights give a class of preferred equity the right to purchase a portion of any future equity financing so that the original ownership percentage is maintained.

Conclusion

In subsequent blogs, I will describe how these provisions typically play out as a venture-capital backed company proceeds with its “exit” either through an Initial Public Offering (IPO) or a sale or wind-up the business. These provisions have a big impact on all classes of equity at exit, in that they determine how much of the value of the company is paid out to each shareholder.

________________________________

[1] This quote and the ensuing discussion are adapted from the AICPA’s Valuation of Privately-Held-Company Equity Securities Issued as Compensation, Appendix H.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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It’s no big news that there weren’t a lot of IPOs in 2009, and hardly any in 2008. In general, IPOs were few and far between in the years after the dot-com bust. Most pundits make the passage of Sarbanes-Oxley in 2002 responsible for this dearth of new offerings.

A recent Grant Thornton study digs a little deeper and identifies 1997 as the peak year for the total number of public companies in the US. Since then and through 2008 the number of listings has declined by almost 40%. This is especially remarkable as listings on other global stock exchanges have increased: the number of listed companies in Hong Kong has almost doubled.

Grant Thornton traces this development back to the advent of online brokerages in 1996 and introduction of new order handling rules in 1997. The decline in listings was already in full swing when the dot-com bubble peaked. The rate of decline has slowed somewhat since Sarbanes-Oxley (between 2004 and 2007: coinciding with the economic recovery), but accelerated again towards 2008.

Grant Thornton argues that the root cause of this depression in listings is not Sarbanes-Oxley, but an array of regulatory changes that were meant to advance low-cost trading (such as decimalizing spreads), but have had the unintended consequence of stripping economic support for the value components (quality sell-side research, capital commitment, and sales) that are needed to support markets, especially for smaller capitalization companies.

There likely is more to it:

The pace of smaller IPOs after the dot.com crash may have been much higher without Sarbanes-Oxley, or with a reasonable exception for small-cap companies. This has combined with decreased investor appetite for “public venture capital” in the US vis-à-vis emerging markets.

Is any of this likely to change?

Grant Thornton makes several recommendations to bridge to more traditional IPOs, such as the establishment of an alternative public market segment that supports a higher fee structure for market makers, as well as private markets with limited access, such as solely to qualified investors. IPOs might pick up in a recovery, but they are unlikely to reach the 360 new issues per year that are calculated as the equilibrium number to avert further erosion of total listings.

Given investor interest in overseas markets compounded by an increase in domestic M&A activity and bankruptcies, a further decline in listings in the US is much more likely until a new equilibrium is found.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Depends. It can take a couple of weeks for a hot technology company, or many months, if the buyers aren’t lining up around the block, which is a rare occurrence these days.

Whereas the timing of a transaction (up-market, down-market, hot technology space, etc.) is certainly of importance to the general consideration of whether or when to sell, the execution time from when the decision to sell has been made until the transaction closes is relevant in any market.

Obviously, there is a time value of money, and one dollar in a couple of weeks is worth more than one dollar in six or nine months. The simple compounding effect gets amplified for companies with a high cost of capital – such as venture capital.

Getting stale

But more than that, once deals are marketed they tend to have a limited shelf-life before they become stale. Interest in the company may be waning, and the economic situation of the company as well as the larger economy can change negatively as time drags on. Any potential acquirer will do a “make or buy” analysis. The assessment can change over time as the deal lingers on.

It is a crucial condition to a successful transaction that a sense of urgency among the buyers be constantly stoked. This holds true for a sale in an auction as well as for negotiated sales.

Confidentiality is another consideration: the longer the deal process lingers, the higher the likelihood that word gets out. This may be an advantage if the company is selling its assets and wants to target the largest possible universe of buyers, but it can be detrimental if it keeps customers from buying its products pending a transaction, or employees start to become nervous over the outcome of the transaction, or competitors start taking dead aim in the marketplace.

Auction 90TM

The Brenner Group has developed a formulated process for the sale of a company: Auction 90™ . As the name implies, in its purest form it takes 90 days from the start of the engagement until a buyer is contracted.

The process has been designed in an auction setting and can be executed as an open auction (where the goal is to maximize exposure) or a limited auction (where a limited number of bidders are corralled along a pre-defined process to expedite the transaction.

Timing

There are several factors that influence the execution time:

1. Asset sale versus stock sale

As the name implies, a company sells only its assets (or a sub-set of its assets) in a piecemeal manner. Any proceeds to the company will then be distributed to debt- and equity holders. In a stock sale, the owners of the company sell their stock to the acquirer, thereby disposing of the company in a single transaction. The assets (and liabilities) will continue to be owned by the company. Usually, asset sales can be executed faster than stock sales, in part because stock sales require more analysis and due diligence by the buyer.

2. Complex due diligence

Obviously, the more there is to a company, the more due diligence there is to do, and the longer it takes for a transaction to close. Complex technology, employees, overseas offices, and contractual relationships all take time to analyze. The further a company is along in terms of customer buy-in, product development, and actual sales, the easier it is for an acquirer to do due diligence.

3. Economic and industry environment

Obviously, deals will take longer in times when everybody is hunkering down and trying to cut costs. There are exceptions to the rule – if companies provide technology or products deemed “mission critical”, deals will still be done expeditiously. For example, Electronic Arts acquired online game company Playfish for $375 million at the same time EA announced layoffs of about 1,500 employees from its core staff.

4. Cash deal, share deal, merger

If the acquirer pays in cash, there is little to analyze. A transaction where the acquirer pays with shares needs additional scrutiny: are the shares registered, or restricted, or readily marketable, what is the trading volume, etc. The more weight on deferred payment, the higher the risk for the seller; especially as the seller has little control over the acquiring company’s operations going forward.

5. Auction, negotiated deal, limited exposure auction

Usually, an auction will lead to a speedier close, as it keeps all participants focused on a deadline. While a negotiated sale for a highly sought-after company can proceed swiftly, undue urgency may not leave the seller the necessary time to investigate other strategic options that could result in a higher price. Read more about auctions in my previous post Going…going…GONE!

Ideally, technology companies are bought, not sold. Employing the right sale strategy ensures an optimum transaction value.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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In the traditional Silicon Valley funding model that worked for many decades, entrepreneurs came up with new ideas, pitched them to Venture Capitalists, and prayed that their idea was unique and that the VC’s found credibility in the management team in order to get funding to build the enterprise.

In the post dot-bomb era, VC’s became increasingly risk adverse, and wanted to fund only those ventures with proven entrepreneurs and only ventures that had already been fleshed out to remove much of the technology risk, leaving only a market risk to conquer.

Now, since the Great Recession, VC’s have gotten even further risk adverse, although they claim otherwise. Today, most VC’s are concerned about their Limited Partners interest in the start-up space, because their own liquidity has been diminished, but probably more importantly, they have had negative returns on the VC sector of investing for over ten years! So the VC’s are looking to invest in deals that might have a reasonably short exit in order to increase their returns. Also, by looking at shorter time frames for exits, they are almost sure to invest in later stage ventures which by their nature have taken some, if not all, of the techno logy risk out of the equation.

The rise of the angel

So what does that leave for early stage entrepreneurs? In the late 1980’s and early 1990’s wealthy individuals became a source of capital for early stage deals. These individuals became known as angel investors. In the late 1990’s, and especially in this decade, these individual angel investors organized themselves into groups. By acting in a group, many angels believe they get the collective intelligence of the members of the group, which broadens their own market for possible investments. They also get to spread their investment risk out, by investing smaller amounts individually into more deals collectively. This formula is beginning to replace the traditional venture capital model.

Angel investors have more tolerance for the time it takes to build a successful business, because they don’t have to answer to limited partners, they only have to look in the mirror and satisfy the reflection looking back at them. Angel investors are prepared to invest in early stage companies, and when structured properly, they are able to see a positive return when an exit does – hopefully – occur. Be aware however, that angels are more intelligent now than they used to be. Today, they also look to how much capital the enterprise will require beyond the angel round. If this amount is large, they might want to have some later stage venture capitalists actually look at the deal to judge their future interest in the team and the space.

So, if we look at the funding order available for entrepreneurs today, the first place they should look after their own family and friends, should be to the organized angel investment groups. They still have to deal with more individual investors who make their own decisions, but they are typically dealing with intelligent, qualified investors. So, we can say that these angel groups have now taken the place of the traditional venture capital early stage funding.

When the entrepreneur has fleshed out the technology, and maybe even the market, traditional sources of venture capital may be available to increment the angels’ investment.

Time will tell whether this change in the funding ecosystem is permanent or temporary. But for now, entrepreneurs need to work with angel groups.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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Pepperdine University recently published its first Private Capital Markets Report, and it is chock full of useful information for entrepreneurs and investors alike.

It is based on an exhaustive survey of commercial bankers, asset-based lenders, mezzanine capital investors, private equity sponsors and venture capitalists. It provides insights into everything from the critical ratios commercial banks expect when extending credit to the average closing fees charged by mezzanine investors.

Rates of Return – what VCs want

What caught my attention and gave this post its title is the calculation of implied expected rates of return of venture investments.

Investors were asked about their expected sales multiple (target sales prices to total venture investment ratio). As can be expected, the average ratio decreases from 8.2x for a “Stage 1” company (Two guys in a garage, or more formally according to AICPA: “No product revenue, limited expense history, incomplete management team with an idea, plan, and possibly some initial product development”) to 3.9x for a “Stage 6” company (“Established financial history of profitable operations or generation of positive cash flows”).

So far so good.

Respondents were then asked about their anticipated time to a liquidity event. Again, as expected, the timeline shortens from an average of 6.2 years for a Stage 1 company to 3.8 years for a Stage 6 company.

With both numbers in hand, the authors then calculated the implied rate of return.

The average implied expected rate of return actually increases from 40.5% for a Stage 1 company to 43.3% for a Stage 6 company.

In other words, this would mean that VCs require a higher rate of return from an investment in a company with lower risk. This does not quite conform to financial theory.

How come?

1. Black Swan Hunting

First, VCs aren’t really going for an average return, but they are looking for the outlier that will carry the return for the portfolio. In essence, they’re “black swan hunting”. The 6.2 year estimate for the time to exit of a Stage 1 company may be a realistic average. But the 8.2x exit multiple might be better understood as a hurdle ratio for a base case: An Early Stage VC investor is unlikely to invest in any company (or at a valuation) that does not have the potential to return such a multiple. In the end, of course, most investments don’t pan out that way. But hopefully, a select few in the portfolio will outpace that number by far.

2. No incentive to invest in early stage deals

Secondly, and questioning the viability of Early Stage Venture Capital investing on a more fundamental level: If above estimates are correct in reflecting the current reality that the expected returns from Early Stage investments aren’t significantly higher than Late Stage investments, who would want to invest in Early Stage deals? And indeed, for the second quarter 2009, an analysis of 89 financings conducted by law firm Fenwick and West pegs the percentage of Series A and Series B rounds at 35% of all financings, down from more than 50% in the third quarter of 2007.

And finally – coming back to the title of this post – I believe that respondents are underestimating the detrimental effect that compounding has on their rate of return: The additional time to exit chips away from a healthy return. I would yet want to meet the Early Stage VC who invests with an expected IRR as low as 40% on an individual investment.

The authors of the Private Capital Markets Report are planning to include actual return estimates for the different stages of investment in future editions of the survey. At that point we will be able to quantify exactly how bad VCs are at their math.

In the meantime, I encourage any investor to participate in the survey.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

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Here at The Brenner Group, we often get comments from our friends in the venture capital and entrepreneurial communities about the burden of 409A compliance and the closely related 123R accounting rules for stock option expensing.

The comments range from expressions of pain and dismay to colorful language that is not suitable for reading at the family dinner table.

For early stage companies, the burden and frustrations can be significant because of the costs and complexity of compliance. Compliance with the rules reduces the efficacy of one of the key tools early stage companies use to compensate and reward employees: low strike price options. It seems to us that the rules would be a prime target for tax reform. Some form of simplified tax treatment would lift this burden from early stage companies and their investors, and would help them to attract and compensate employees.

Speaking of tax reform, if you haven’t seen it, information about a new documentary called “An Inconvenient Tax” has been making the rounds on the blogosphere. The trailer and website actually come across as non-partisan. The film makers indicate they have interviewed individuals with a range of political viewpoints, from Noam Chomsky to Steve Forbes, economists, and others. I am not sure what the film makers are actually advocating in terms of solutions, but it would certainly be a positive if the film prompts informed tax debate and real reform.

The documentary was profiled a few weeks ago by a blog at the Wall Street Journal. Here is the link:  http://blogs.wsj.com/wallet/2008/09/22/inside-the-brain-ofthe-creators-of-an-inconvenient-tax/?mod=rss_WSJBlog 

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Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

In my last post, I discussed size considerations of individual venture capital firms.

If VC firms ought to be smaller, what does that say about the VC industry as a whole?

VCs have been investing more than $20 billion each year since 1998. In 1999/2000 investments shot up to over $20 billion per quarter, but went down sharply afterwards, then starting a slow upward trend to an annualized rate of about $30 billion at the end of 2008 when the current economic crisis kicked in.

A Kauffman Foundation report by business-blogger-at-large Paul Kedrosky (his blog: infectious greed) pegs the reasonable size of annual venture investments in the US at $12 billion (instead of the $30 billion rate we saw in 2008). He largely gets there from return-considerations, as well as using a fraction of overall GDP.

Further suggesting the vc industry is contracting Bill Gurley from Benchmark gives a very good summary of how venture capital will likely get caught in the asset allocation squeeze (or the “denominator effect”): a typical institutional investor may allocate 5% of all assets under management to venture capital. As the total assets shrink because the value of all other asset classes such as stocks and bonds shrink, so will the money available for venture capital. Exacerbating this trend – and making it a long-term effect – would be a lower relative allocation. Whereas institutional investors have increased their relative allocation to venture capital over time, now may be the time to reduce it, following dismal returns from the industry for much of the last decade. The 5% could very well be cut in half – along with the venture capital industry. Gurley’s outlook still trends towards a “stabilized market size of well over $15B a year”.

Eventually, funds disbursed by venture capital firms will follow what they’ve raised. And little did they raise indeed so far in 2009: A dismal $1.7 billion was raised by VC firms from limited partners in the second quarter of 2009. Hopefully, we’ll see some recovery from such low numbers: This would lead to a very small industry indeed.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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What is the right size for venture funds?

Veteran investor Alan Patrikof is musing in a recent piece in The New York Times about the “good old times” when venture funds were $100 million at most.

So why should VC-Firms be smaller?

1. It takes longer for VCs to reap their profits:

The time from VC-financing to M&A exit has grown substantially. From about 2 years in 2001 to over 7 years in 2007. And the time value of money comes at a high price to VCs: In order to realize a 50% IRR on an individual investment, it would have to yield a 17-fold return after 7 years, versus a 2 ½ -fold return after two years. Not that such returns aren’t possible, but given the substantial investments of large VC firms, those need to be some hefty exits, and:

2. There aren’t that many supersized exits out there:

The average (disclosed) M&A deal size has shrunk to about $50 million in the US in Q1 2009 (with Q2 faring somewhat better) according to Thomson Reuters and NVCA reports. Most M&A deals are not disclosed. Most undisclosed M&A deals are much smaller.

So if venture investors owned 50% of a company at the time of the M&A transaction, the proceeds would yield them $25 million. Which is exactly the average amount of VC investment prior to an M&A exit in Q1 2008. That doesn’t leave much room for any return on investment. And although there are some encouraging signs for technology IPOs, the vast majority of exits are currently in the form of M&A. Even discounting the financial crisis: IPOs these days are a large-bank affair: a company will need to provide sufficient float to attract an active market in its shares; in the order of at least $50 million; at valuations of north of $250 million.

Will any of this change?

We will certainly see more exit activity and better valuations at some point. But a return to the “small IPO” is unlikely. And to build a company with an exit value of $50 – $100 million, it shouldn’t take more than $5 million for the math to make sense – which would call for venture capital firms that can deploy these relatively small amounts of money efficiently.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Masters Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is a Member of the Board of the German American Business Association (GABA).

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It goes without saying now-a-days that emerging firms do everything they can to stretch their dollar. Just about every startup that I run into informs me that they have installed a copy of QuickBooks, so the finance part of their business is “covered.” When I ask who runs QuickBooks, the inevitable answer is the “receptionist/office manager” or “I do it myself so I know things are right.”

From a dozen years of financial consulting, I have seen far too many companies go far too long without paying management attention to finance, with often fatal results. While QuickBooks is a competent system, it is not a substitute for financial management in your firm and poor input to QuickBooks will inevitably result in inaccurate output and sub-optimal decision-making.

What QuickBooks won’t do for you

Accounting can be pretty simple when the company is just starting out. But problems in a business multiply once there are revenues. Every revenue stage firm must have some form of financial management (i.e. Controller or CFO) to avoid serious compliance and operational issues. Yet I find few companies have taken the steps to shore up this important part of their business. For example, invoices can be issued and paid from QuickBooks but I still find companies that are not collecting sales and use tax because they did not know they had to.

Here is a short list of F&A issues that will not be solved solely by a copy of QuickBooks:

• Tax compliance from Federal through local

• Decision support from an accurate financial model

• Internal control routines that can protect against fraud and waste

• Accurate financial reporting to investors and lenders on a GAAP basis

• Preparation of payroll and provision for employee benefits and retirement plans

• Credit extension and collection of accounts receivable

• Effective management of inventories

• Obtaining appropriate business insurance

• Managing a financial or tax audit

• Managing banking and debt relationships

Starting out on the right foot is essential

Often I have been called into a company to fix issues that would have been simple to solve when the company was much smaller, or worse when something fatal has already occurred and major restructuring or business termination is required. Essentially the business decision required is “pay now or suffer serious unintended consequences down the road.”

I urge each entrepreneur to establish a financial plan for his/her business that includes how the financial function will be managed and what procedures and controls will be needed as the firm grows. Outside resources are frequently required to do this and can include auditors, tax providers, insurance agents, payroll and HR services, general and specialized law firms and interim financial managers.

Rick Kadet is Vice President and Senior CFO Management Consultant with The Brenner Group, where he has engaged with over 50 valley firms as Consulting CFO or financial advisor over an eleven year period. Prior experience to The Brenner Group includes CFO and C level operational positions at Versant Corporation; InfoSpan Corporation;, Cadre Technologies, Inc.; and Sarama Industries. Rick began his career with General Electric Company and is a graduate of Arizona State University.

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Ivan Gaviria, an attorney at Gunderson Dettmer’s Silicon Valley office, recently posted 5 classic (and costly) mistakes startups make with their people.

http://www.undertheradarblog.com/blog/5-classic-and-costly-mistakes-startups-make-with-their-people-5/

What made #5 on his list? Ignoring Internal Revenue Code 409A.

Avoid tax penalties and painful employee complications

His short note makes several excellent points. 409A has changed board practices at VC backed technology companies for setting the exercise prices on stock option grants. He points out the potential nasty tax penalties of non-compliance as well as the “safe harbors” in the 409A regulations. And he stresses the importance to the founders of startups to understand these safe harbors and the possible unpleasant side effects on optionees.

Of course, we’re in the business of providing 409A valuations in accordance with the tax code’s safe harbor provisions. But we see many boards not committed to 409A compliance, and it is a recipe for downstream pain. We can’t make 409A go away, but we can make the process of compliance a bit easier. The thing to understand is that valuation has become part of the standard accounting and tax compliance process for early stage companies.

409A compliance makes an M&A event go smoother

As Mr. Gaviria has cautioned, inadvertent problems with 409A compliance can lead to ‘…significant cost and delay when they have to be solved under the scrutiny of an acquiring company’s accountants and counsel.” I would add that the costs and delays can also occur at the point a company engages financial auditors for any reason, and the scrutiny gets more intense as the company prepares for an IPO or acquisition.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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So, your venture investors have decided to stop funding your company, and you are about to run out of cash. What are your options? There are a number of alternatives, depending on whether your company has built significant value or not.

Seek sources of capital other than venture capital

If you have built significant value, you can pursue different types of capital for sustenance or liquidity. There are exceptions, but for the most part the IPO windows are virtually closed, regardless of how much value you have created.

So, if your historical financial investors (e.g. venture capitalists) have run out of the willingness or ability to continue funding your business while you wait for a great payday, you need to know that there are other ways to fund your business. One such way is to look for a strategic investor. These are typically not traditional financial investors but may be one of your customers or suppliers, or even one of your competitors. This investor might also be a company that is looking to expand through new technology. These parties may see value in funding the company to continue to watch you grow or to assure their supply chains are maintained. These investors might be interested in investing in you to see if they should consider acquiring you at some point in the future. Or, they may start a discussion about an investment and determine that acquiring you in the current market would be advantageous to all parties. Valuations in these circumstances are typically much better than a traditional financial investor, because of the different motivations which they bring to the table. To accomplish this strategy successfully, you should enlist the services of a competent financial advisor, who has managed these sorts of transactions.

Final liquidity option – selling your company or its assets

In our last blog, we spoke about restructuring in the difficult times. However, sometimes restructuring cannot work and forces the board to look at ways to receive anything, even a small amount, representing the value of the assets of the business. In most venture capital backed technology companies, there are primarily two types of assets: fixed assets which you can see and touch: furniture, computers, servers, lab equipment, etc.; and intangible assets which are the ones that probably have the most value. Intangible assets include intellectual property, such as patents or patent applications. Depending on your industry, and the strength of your patent portfolio, many companies might be interested in acquiring these assets. Defensive patents are those which other companies might want to purchase to prevent or block other companies from developing new products which compete with a core business. Offensive patents are those which a company acquires to allow it to pursue a strategic business opportunity faster and with greater defensibility. Lastly, the longer you can maintain the core of the business, such as the development team, the more likely it might be that someone interested in the intellectual property might also be interested in the team that developed it, and might pay a premium to acquire this.

If you cannot keep the team together long enough to see if there would be a buyer for the intellectual property and the team, selling the fixed assets usually requires retaining a financial advisor to conduct the auction of these assets. The value that will be received at auction is typically very low, but can generate a little cash to allow you to conduct a sale of the intangible assets. Retaining a financial advisor with experience in selling the intangible assets can result in better results for the stakeholders, which are the creditors and/or the shareholders.

So while liquidity events come in different sizes and shapes, there is always a way to generate some liquidity for your stakeholders.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

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A news service for the valuation profession recently profiled a discussion of the “H Model” among valuation professionals (BV Wire Issue 83-1 published August 5, 2009 by Business Valuation Resources, LLP). Since we sometimes include the H Model in valuations of early stage technology companies performed at The Brenner Group, I thought I would add a few comments.

Many people are familiar with the concept of a Discounted Cash Flow (DCF) analysis which calculates the value of a firm as the present value of its future cash flows discounted at the firm’s cost of capital. The H Model is a form of discounted cash flow analysis in which the firm’s cash flow is modeled in two stages. The first stage is a relatively short period time in which the firm is expected to experience a high rate of growth and the second stage is the long term sustainable growth rate of the firm. One of the features of the H Model is the high growth period is not modeled assuming a fixed high rate of growth, but the model reduces the growth rate linearly through the initial stage, until the long term growth rate is reached. The model also allows for the use of different cost of capital assumptions in the two stages, allowing one to model the high growth period according to a higher risk, higher capital cost profile, and then reducing the cost of capital in the second stage to reflect the expectation that the company reaches a stable level of operation and lower risk conditions.

H Model is appealing for early stage technology companies

Here’s a hypothetical example. Assume a company has commercially launched its first products or services, and develops financial projections covering a three to five year period. The projections portray the company achieving sufficient scale and profitability to proceed with an IPO at the end of the forecast period (assuming, of course, the equity markets cooperate).

The H Model allows us to model this situation according to three stages. The first stage represents the three to five years the company has projected its initial period of growth. The company may have negative cash flows for much of its first stage of development, and may be deemed high-risk, with a commensurate high cost of capital. In this first stage, we may simply rely on the cash flows contained in the company’s financial projections. The H Model is then used for stages two and three. In this hypothetical example, the H Model’s high growth stage is used to model the continued growth in cash flows following the IPO. While not within the scope of the company’s financial projections, there may be an expectation that growth will not drop off suddenly after the IPO. If cash flows grow 50% in the year before an IPO, it may be reasonable to assume that growth trends downwards for the several years following the IPO until the sustainable level is reached. The H Model’s sustainable growth stage is then used to model the value, assuming the company has achieved its full potential scale of operation and continues to grow at a long term, sustainable rate.

A key benefit of the H Model is that it appears to fit the financial history of many venture capital backed technology companies. One can exhume a company’s actual historical financial results and see a very common pattern of results. One can then see, in the first years of operation, the negative cash flows. One can observe the growth in revenues, the improvement in profitability and cash flow results through the IPO, and on into the years following the IPO.

Of course, one may also see the volatility of market value after the IPO (positive and negative), and periods of stronger and weaker financial results, rather than a halcyon existence of sustained growth.

A formal valuation would include multiple valuation models

As a final note, the applicability of the H Model is subject to the specific facts, circumstances, and expectations that are unique to each company. While the H Model is one form of discounted cash flow analysis, there are others which may also be used in any particular valuation. In general, the H Model analysis performed would also be accompanied by other valuation approaches (such as a Market Approach), as appropriate, within a formal valuation report.

The interested reader can find out more about the H Model in Chapter 4 of Financial Valuation, Application and Models, 2nd Edition by James R. Hitchner (Wiley, 2nd Ed., 2006). If the reader is in the CFA program, multi-stage cash flow valuation models are addressed in Chapter 3 of Equity Asset Valuation by John D. Stowe, CFA, Thomas R. Robinson, CFA, Jerald E. Pinto, CFA and Dennis W. McLeavey, CFA (CFA Institute, 2007). Some writers use the term H Model to refer to a specific dividend discount model. However, other authors apply the term more generally as a method of cash-flow based valuation, as I do here.

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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Discounts for Lack of Marketability (“DLOM”) often play an important role in the valuation of privately held companies. This is because we often develop an indication of the value of a company as if it were publicly traded, and then adjust the value to reflect the fact that its stock cannot be rapidly sold on a public exchange.

In light of the turmoil in the equity markets over the past eighteen months, some have conjectured that the difference in values between public and private companies has gotten wider. An intriguing set of studies conducted by Ronald M. Seaman shine some light on this issue.

LEAPS Study Provides Insight

Seaman studied a form of stock options referred to as LEAPS (“Long-Term Equity Anticipation Securities”). These are stock options (call and put options) listed on the Chicago Board of Exchange and elsewhere, with extended terms until maturity (Seaman has studied LEAPS with maturities that have typically ranged from 14 to 30 months). Put options can be purchased by an investor to hedge against a decline in stock value. According to Seaman, “…the cost of a LEAPS put option, expressed as a percentage of the price of the underlying stock, measures the cost of price protection against a loss of value of the stock.” Seamans postures that this cost of price protection is a proxy for the relative lack of marketability.

Most notably, Seaman conducted a study of LEAPS prices in 2006 which he has updated with prices measured in November 2008. The changes in discounts between these two periods of time are eye-opening. Obviously, equity markets in 2006 were relatively benign, while the markets in November of 2008 were in a state of extraordinary turmoil. For instance, Seaman found that the median cost of price protection for companies with revenues less than $100 million went from 27.3% (for 18 month terms) in 2006 to 47.2% (for 14 month terms) in 2008. Overall, Seaman observed, “Discounts in November 2008 were double or greater the discounts in October 2006”.

The use of options models (and the supporting LEAPS studies) has been gaining increasing visibility as a method for quantifying DLOMs used in valuation studies. At a minimum, evidence of the kind supplied by Seaman challenges the analyst to consider both company specific facts and circumstances, as well as the overall economic climate and equity market conditions, in the determination of marketability discounts.

(The source of all quotes is “Minimum Marketability Discounts”–4th Edition, A Study of Discounts for Lack of Marketability Based on LEAPS Put Options in November 2008 by Ronald M. Seaman, FASA, March 2009. A copy of the study may be obtained at http://www.dlom-info.com/)

Bill Denebeim is a Vice President of The Brenner Group and has more than twenty years experience providing financial, regulatory and operational consulting services to executive management and investors of technology companies. Bill received his M.S. in Operations Research from Stanford University and his B.A. degree in Economics and English from the University of California at Berkeley. Bill is a holder of the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of San Francisco.

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In response to today’s current market conditions, The Brenner Group is putting our experience to work and has developed and launched “The Brenner Group Education Series” – practical, educational seminars for clients, partners and entrepreneurs to address issues that are important to the technology community.

Our first seminar, “Issues Confronting the Financial Expert” is scheduled for Wednesday, July 22nd from 8:00-9:30am and focuses on key issues and challenges facing financial expert witnesses and litigating attorneys in the development and presentation of financial analysis testimony, with a particular emphasis on valuation. As an approved MCLE provided we are pleased to provide one hour of credit for this session.

Just a few of the topics to be covered …….

• The role of the financial expert witness.

• The court’s expectations and rules of evidence for valuation testimony.

• Daubert challenges.

• The differing definitions of value encountered in litigation.

• The various authorities, professional organizations, and professional standards for valuation.

Look for additional seminars in the months ahead.

Read more about Silicon Valley news, trends, and commentary in The Brenner Banner

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