Venture Capital Valuation

Case Studies and Methodology

Lorenzo Carver

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470908280
• eBook ISBN: 9781118182338
• Edition: 1
• Topic: Commerce
• Subtopic: Finances d'entreprise

Very few of the decision makers involved in a venture backed company have a definitive understanding of how valuation techniques are being applied to their financial statements and their decision making process. This casebook provides a quick and accurate road map on how valuation techniques used for tax, financial reporting and deal structure impact a company's past, present and future. The book includes real world case studies to simplify this complex subject for the practitioners serving companies, the founders and executives running the companies, and the investors that fund the companies.

CHAPTER 1
Using Facebook, Twitter, and LinkedIn to Explain VC Valuation Gains and Losses: How VCs, Angels, Founders, and Employees Give Up Investment Cash Flow Every Day

“They engaged in discovery, which gave them access to a good deal of information about their opponents. They brought half-a-dozen lawyers to the mediation. Howard Winklevoss—father of Cameron and Tyler, former accounting professor at Wharton School of Business and an expert in valuation—also participated.”

—Excerpt United States Court of Appeals for the Ninth Circuit Opinion, Facebook v. ConnectU

How can someone realistically use the words “losses” in the same sentence as the names of three of the most successful venture-backed companies in recent history? Indeed, these three companies, along with three or four others, will likely account for 80% of IRRs reported by all U.S. venture-capital funds started after 9/11. So how could anyone lose on one of these transactions? The obvious answer would be the parties referenced in the quote preceding this chapter, the Plaintiffs in the Facebook ConnectU case. To put a face, or set of faces, with the parties, the ConnectU side includes the twin brothers portrayed in the movie The Social Network.

DID VALUATION IGNORANCE COST CONNECTU (AND THE WINKLEVOSSES) $50MM?

With half a dozen lawyers, and a father who was an “expert in valuation,” how did the ConnectU team miss the obvious fact that it was receiving common shares that are, of course, worth less than preferred shares? To appreciate the answer, here's a brief summary of the lawsuits involved and what 409A is, for those not familiar.

The Facebook, ConnectU Related Lawsuits Timeline

• September 2004: Started with Facebook being sued for, basically, taking the “idea” away from ConnectU (Tyler and Cameron Winklevoss and Divya Narendra)
  • This happened about four months after Peter Thiel (founder of PayPal) invested $500,000 for around “10% of the company [Facebook]”
• April 2007: IRS issues final regulations for Section 409A, which among other things, effectively require venture-funded companies to have third-party appraisals done in order to get a safe harbor from potential penalties associated with mispriced options
• October 2007: Microsoft Invests $240 million in Facebook for 1.6% $240MM ÷ 1.6% = a $15 billion “valuation,” according to press reports
• November 2007: Hong Kong billionaire Li Ka-shing invests $60 million in Facebook, apparently for the same Series D shares Microsoft received
• January 2008: 409A regulations become “effective”
• June 2008: Facebook settles with ConnectU founders for “$65 million” calculated (approximately) as follows—$20 million in Cash +$45 million in common stock = approximately $65 million
• August 2008: Press reports Facebook plans to allow employees to sell some of their shares at “internal” (409A) valuation of around $4 billion
• May 2009: DST invests $200MM in Facebook at a reported “valuation” of $10 billion
• July 2009: Michael Arrington reports that DST will offer employees $14.77 per share for their common stock, and they have 20 days to accept the offer
• July 2009: Sharespost “opens for business,” with the sale of Tesla shares on a secondary market for private company shares, according to the New York Times
• December 2009: Zynga rumored (by Eric Eldon of Inside Social Games) to be offering exits to employees funded by DST at “$19 per share”
• February 2010: Facebook investor Li Ka-shing Foundation invests in leading secondary market for Facebook shares, “secondmarket” at a reported $150 million valuation
• January 2011: DST and Goldman invest in Facebook at a $50 billion “valuation”

As stated in the ConnectU Appeal Brief, “… it was a matter of simple math to conclude that each share of Facebook in February 2008 was worth approximately $35.90. …” After negotiating a settlement with Facebook whereby ConnectU would essentially be acquired by Facebook in exchange for $20 million in cash and $45 million in common stock, the ConnectU plaintiffs discovered the existence of a 409A valuation report issued by Houlihan and Loukie that “valued” Facebook common stock at fair market value. Apparently, the ConnectU team believed their common stock was equal in value to the value of the preferred stock purchased by Microsoft months earlier. Considering the fact that nearly all 409A valuations undervalue the company and simultaneously overvalue the common stock, this mistake is not that uncommon. Millions of employees, tens of thousands of angels, thousands of founders, and even a few hundred VCs make the same mistake every year. However, few if any of those parties seek to rectify their mistakes through litigation, despite having substantially less access to information and fewer resources than the Winklevosses had according to court documents.

AN EXPERT DOESN'T NEED A 409A VALUATION WHEN HE OR SHE HAS A CERTIFICATE AND BASIC MATH

Despite the shortcomings of 409A valuations practices, today it takes only 3 to 15 minutes for a valuation expert familiar with venture-funded companies to give an approximate (rough) estimate of the value of common stock compared to the value of the last round of preferred financing. Even if the 409A valuation expert's conclusions are widely off the mark, the expert will still conclude that if Microsoft paid $35.90 per share for its preferred stock, and someone received common stock a few months later, that common stock is probably not worth more than 50% of what Microsoft paid for its preferred stock, unless an IPO is imminent.

This may sound like a simple rule, but there's real science behind it, and much of that science was initiated by the IRS in response to the economic devastation realized by those in the liquor business as a result of prohibition. Ironically, following the ConnectU settlement, many of the factors that would have caused a 409A valuator to arrive at a lower value for the common stock received by the ConnectU plaintiffs were superseded by a force that impacted each of the companies we mention here as well as the three other companies responsible for “80% of venture fund IRRs” produced by funds started after 9/11.

That superseding force essentially became the market maker in the world of social media investments and their name was DST, or Digital Sky Technologies. Without the bets they placed on Facebook, Zynga, and Groupon, it's unlikely that LinkedIn's IPO would ever spawn a $9 billion market cap so quickly or that Twitter would command a $10 billion “valuation.” In fact, it's conceivable that without DST's primary and secondary investments in Facebook, venture capital, social media, and possibly a key part of the U.S. economy might look very different today.

VALUING FACEBOOK'S COMMON STOCK COMPARED TO PREFERRED STOCK IN MINUTES

The “trick” we are about to show applies to 90% or more of venture-funded companies in existence in the United States and around the globe as of the writing of this book. However, it no longer applies to Facebook, for reasons we will touch upon briefly later in the chapter. But in late 2007 and early 2008, when the ConnectU and Facebook dispute was about to reach a settlement, it was still applicable to Facebook's common stock. The Winklevosses could have determined that the “simple math” they were using to value the common stock based on the estimated Series D price paid by Microsoft was simply wrong.

Different Standards of “Value”

The first point concerning differences between the price Microsoft paid for preferred stock and the “value” of Facebook's common stock on the same date was evident to members of the press, which noted that the transaction was “strategic” in nature. However, what exactly does that mean from a valuation standpoint?

If you've ever read a valuation report, one of the first things you will see in the report is the “Standard of Value” being used to arrive at a conclusion. In the case of a 409A valuation, that standard is “Fair Market Value” as defined by the IRS, which is very different than the price a strategic investor or even an investing partner at a VC fund would be willing to pay.

Different Type of Ownership Interest Being Valued

A minority, or non-controlling, interest in a privately held company is generally worth less than a controlling interest. There have been lots of studies conducted to quantify the difference in value, but even if we were to conservatively say that the difference is 5% or 10% across the board, we would expect to get a lower value for a partial interest in common stock, versus an interest that gave us control of a class of preferred. Again, we will get into those details a little more in a moment, but for now, we have two widely accepted differences between the value of the Series D shares Microsoft purchased and the common shares that ConnectU was to have accepted in lieu of $45 million in cash.

Marketability, Liquidity, and Volatility

Perhaps the biggest difference between the price per share Microsoft paid for its preferred stock versus the fair market value of the shares of common stock ConnectU was negotiating is the applicable discount for lack of marketability, or DLOM. This area requires a somewhat more involved discussion, and also relates to the value of control. But as with the discount for lack of control we mentioned, an estimate of 40% to 45% is generally easy to support, assuming Facebook is not expected to go public or be acquired in the next three years or so. We can even quantify the 40% to 45% discount using ...

Table of contents

• Cover
• Table of Contents
• INTRODUCTION
• CHAPTER 1: Using Facebook, Twitter, and LinkedIn to Explain VC Valuation Gains and Losses
• CHAPTER 2: Should Venture-Backed Companies Even Consider a DCF Model?
• CHAPTER 3: Valuation Methods versus Allocation Methods Regarding Zogenix
• CHAPTER 4: Applying the Typical DCF Model to a Venture-Backed Company Hardly Ever Works
• CHAPTER 5: “Enterprise Value” + “Allocation Methods” = Value Destruction
• CHAPTER 6: Why You Should D.O.W.T. (Doubt) Venture Capital Returns—Option Pool Reserve
• CHAPTER 7: If Valuation Can't Make You Money, Do You Really Need It?
• CHAPTER 8: Don't Hate the Appraiser (Blame the Auditor Instead)
• CHAPTER 9: Don't Blame the Auditors (Blame the Practice Aid Instead)
• CHAPTER 10: Now That You Understand Venture Capital Valuation, Share It
• About the Author
• Index
• End User License Agreement