The Dangers of Relying on Implied Valuations
The Dangers of Relying on Implied Valuations
Relying too much on implied value derived from a deal’s price can cause reporting, compensation, and other issues for management teams.
This article was originally published in Private Funds CFO.
In a perfect world, the fundamental valuation of a company and its implied value from an external investment should be consistent. But our experience has often shown significant differences between the valuation derived from a fundamental analysis of the company and that implied from investments in the company. Those discrepancies can pose significant issues for management teams post-acquisition. Let’s explore some of those issues.
Discrepancies between fundamental analysis and investments
First, it should be noted that, in most situations, the share price on which a private equity fund often bases an acquisition’s value when using an implied valuation is not that of the common equity of the acquired entity. A venture capital or private equity investment in a company likely involves preferred stock convertible into common equity that hold preferences and other rights not available to common stockholders. However, the implied value disclosed from a venture capital or private equity investment often ignores these preferences when calculating total company value and assumes all securities are pari passu and have equal rights. So, if the company has additional preferred stock from prior investment rounds as well as common equity and options, those securities are likely not equivalent to the $10 per share just paid. Nevertheless, what is often disclosed as the implied value of the company is derived simply from the $10 per share times total diluted shares outstanding (including the prior preferred, common equity, and options). Unless there is an imminent liquidity event, that is not the correct way to determine fair market value.
The common equity and potentially preferred stock issued prior to the recent raise should be valued at a discount to the newly issued preferred stock to account for the different preferences. Therefore, the theoretically correct value of the overall business will be less than what is derived if assuming the same price on a 100% diluted basis. The discount can be significant depending on the specific rights attached to the latest preferred round.
The discrepancy between the implied deal value and the fundamental value can pose issues under several situations, including but not limited to, issuing options, the determination of the private equity’s mark for limited partnerships, or the value of rollover equity as part of an acquisition.
Impact on options analysis
In addition to the purpose and intent of incentivizing employees, issuing options has financial reporting and tax reporting consequences. For tax purposes, options may not be issued below fair market value without tax consequences. If options are issued at the deal implied value, then that is likely higher than fair market value. No tax issue there, but there is a potential disconnect with incentivizing employees, as they will see an underwater strike price. This is not necessarily a good way to incentivize the employee base. Although, theoretically correct, understanding and internally communicating why the difference exists is important.
Impact on establishing private equity mark
A private equity group often provides marks on its investments to limited partnership holders. When the subject company receives an external fair market value or fair value determination of its common equity for financial reporting and tax purposes, this conclusion may differ from the internal mark, creating a potential discrepancy the private equity fund needs to reconcile. Once again, an understanding of why the differences exist is important to ensure consistency.
Impact on rollover equity
Differences often arise between the value assumed for rollover equity included as part of the consideration in a deal and the fair value of that rollover equity when determined for financial reporting purposes. Rollover equity may be part of a transaction consideration when the seller remains actively involved with the buyer post-transaction and receives equity in the buyer. The ultimate price is part of the negotiations between the buyer and seller. A common way to determine the equity price is to leverage a recent capital raise when available. A recent raise is easy to point to as support for value.
However, as highlighted earlier, the price is generally based on preferred equity, not subordinated equity such as common, which is often the for the form rollover equity takes (i.e., a subordinated class to the equity held by the investment group). Following the transaction close, the company must conduct an analysis for financial reporting purposes, which will include the valuation of the equity. Given the earlier discussion, the price determined for the rollover equity will likely be at a discount to that assumed in the deal. Neither has been done wrong here; they simply have different underlying assumptions. The deal value essentially assumes an immediate exit with all shareholders receiving the same per share value. Under financial reporting guidelines, the analysis must consider the timing of an actual exit and account for the rights and preferences of each class of stock.
This is not a problem in and of itself, but it can provide challenges internally with regards to optics. The seller suddenly sees a significantly different value for the shares they just received and may feel that the transaction was not completed in good faith. However, the fundamental differences between stated value used for financial reporting and the value implied from prior investments or a transaction simply use different premises (i.e., assuming a fully diluted basis and current exit vs the theoretical construct under financial reporting requirements).
Discrepancies arise above and beyond different premises
It is clear that implied value and fundamental value can differ for explainable reasons. In each example above, the equity value may differ for the reasons explained, but the overall enterprise value of the business remains the same. They are simply coming at the equity valuation from different angles. The issues that arise, then, are generally issues of understanding and communication. However, we have seen situations where the implied deal value and fundamental value do not reconcile even after consideration of the discount for different rights and privileges. Ultimately, this implies the underlying assumptions used in determining the enterprise value differ.
For example, assume a recent fundamental analysis of a company indicates an enterprise value of $1 billion. The valuation was performed using the traditional approaches mentioned earlier by a reputable valuation expert in June. The company provided a forecast used in the discounted cash flow method, and the valuation expert calculated a market-based discount rate of 15 percent. In addition, the conclusions were supported by market multiples of 6.5x revenue derived from comparable publicly traded companies (the company is an earlier-stage SaaS company). However, two months later, the company receives an external investment that implies a $2.25 billion value.
Can such a gap reasonably exist? From a theoretical valuation perspective, no. Assuming there have been no major changes in forecast or performance of the company, the implied multiple is approximately 14.5x revenue at the $2.25 billion value, compared to only 6.5x two months earlier. The $2.25 billion value would also imply a materially lower discount rate than the 15 percent used initially (once again, assuming no material changes to the forecast). Detailed diligence must be conducted to determine why such a difference arose within two months. Was it a new, external investor or an insider? Did they conduct a full diligence and review the same forecasts used in the previous valuation? Did the new investment have material preferences or dividends?
There are many other likely questions that need to be discussed with management, but if no apparent reason arises for the material increase in value, then the new investment and resulting implied value must be considered in any new analysis. Several approaches to help reconcile the value discrepancy could be appropriate depending on specific facts and circumstances. But ultimately, if the underlying assumptions used in the fundamental valuation cannot support the value implied from the deal, scenarios incorporating the market perspective must be taken into account. This data is highly relevant and should not be ignored.