In my 20 years in the valuation industry, the main conclusion I have drawn is the way we value private companies under IRC section 409A is inherently flawed. After working with several companies through the IPO process, I can anecdotally say that the last 409A valuation for a company is usually 20% to 30% lower than the initial public offering price. This has also been the case following an acquisition and is clearly true if a startup goes out of business. Traditional valuation methodologies are consistently producing less than accurate results and after considering the industry’s valuation toolkit it’s easy to understand why.
To complete a 409A valuation most firms use one (or a combination) of these imperfect methods:
1. Market Approach: The Guideline Company Method
This approach uses revenue information from public companies to determine a private company valuation. We must use public company comparables because data on private companies isn’t open and available to use.
Why it’s flawed:
Most smaller private companies have limited revenue, are focusing on one product and have yet to prove if they are valuable to the market. This is the opposite of large, established and diversified public companies. We are comparing apples to oranges.
2. Market Approach: Mergers and Acquisitions Method
This approach uses the sale price of a merger or acquisition of comparable companies to determine the value of a private company. This approach is used to combat the issue of using large companies to value small ones.
Why it’s flawed:
Very little information is disclosed to the public in a private company acquisition. The revenue of the acquired company, the purchase price or many other important pieces of data are typically unavailable. So, the industry often turns to public company acquisitions. But once again, we’re forced to look at large public companies acquiring other publicly traded enterprises. It’s much harder to accurately value private companies using this data since public companies often pay premiums to acquire companies for strategic positioning
3. Market Approach: Benchmarking to a Company’s Last Funding Round using a Black–Scholes Model
Analysts will look internally at a company’s own financing, usually the most recent round of funding, to extrapolate a company’s value. To try and address differences in funding rounds, terms and share classes we turn to the Black-Scholes model.
Why it’s flawed:
The model assumes a bell curve distribution. However, startups are usually either unicorns or flops, there isn’t much in between. Using the log-normal model often doesn’t reflect what happens at a startup, so using it to value companies often results in less than accurate results.
4. Income Approach: Present Value of Future Income When companies provide a five-year revenue projection, these projections are often used to determine the present value of a future success.
Why it’s flawed?
Relying on a five-year projection from an early stage startup that can barely plan the next 6 months won’t produce anything of value. Startups pivot, go under and expand without much predictability. Asking a startup to develop a reliable long-term financial plan is usually a fool’s errand. During my time in the industry, I can count on one hand the number of companies that have accurately projected and achieved a long-term financial plan during the startup phase of the business.
5. Asset Approach
An asset-based approach (cost approach) is designed to determine the value of what the company has created. An analyst will take any assets the company has (salaries and physical collateral) and subtract the total debt. This process is used to determine how much money it would take to recreate the product.
Why it’s flawed?
Accurately reflecting the true cost can be difficult when salaries are not public. Picking a market salary rate ends up being highly subjective. Secondly, the asset approach doesn’t consider any intangible value of the company. The brand, customers, patents or anything else not directly related to costs are not included in the valuation.
So, what is the solution?
At Carta, we believe it is unlocking private market data. Our goal is to build a database of private company transactions to use in our valuations. By using private company comparables and mergers we will get data that more accurately reflects the true lifecycle of a private company. We will use the information to build models based on the actual funding rounds, revenue, dissolution, and acquisitions of private companies. We plan to use this data to better understand the private sector and produce more accurate valuations.
Of course, the accounting world moves slowly. We don’t expect any new guidance on 409A valuations to happen anytime soon. An even bigger hurdle will be for a reviewer to approve this new approach. Luckily, we have time to figure out a solution, slowly layering in our new approach using private data to support traditional valuation conclusions.
For now, Carta has created a valuation process that produces the most accurate valuations possible while using these less than ideal traditional models. We combine our team of valuation experts, with software, that allows us to increase accuracy and efficiency. With the help of software, our analysts can spend more time vetting assumptions, digging into public companies, and examining transactions, while software double checks for errors and outliers. We find the best apple that looks the most like the orange.