Early-Stage Company Valuations All Equity Classes May Not Be Equal
Early-Stage Company Valuations All Equity Classes May Not Be Equal
Capital raises for early-stage companies may garner headlines with 10-figure valuations, but that may not reflect an accurate company value.
In Silicon Valley, it seems like every day there is news about a company raising a new round of financing through a preferred stock issuance. Media outlets and publications like CrunchBase and Pitchbook may report an implied total company valuation in the billions of dollars and feature headlines such as, “Company X recently raised $100 million in a Series C preferred stock round at an implied total company valuation of $1.0 billion.” What exactly does that mean? Is that the correct way to think about the implied value of the total equity of the company? This is particularly important for companies that are issuing common stock options at the same time as the financing round and also for shareholders that are doing estate planning transactions with their shares on or shortly after the date of the capital raise.
The main consideration being that common stock and preferred stock do not have the same rights, preferences, and incentives, and, thus, may not be of equal value. Careful analysis is required to determine the value of common stock, common stock options, and previously issued rounds of preferred stock relative to the price paid by investors for the newly issued preferred stock.
Preferred Shares and Implied Value
When a news outlet highlights a total-company valuation based on a recent round of financing, they are typically taking the amount of money raised and simply dividing that by the fully diluted ownership stake of the new investors. For instance, if the $100 million Series C financing resulted in the new Series C investors having 10% of the total fully diluted shares outstanding, regardless of class or series, the news article will usually report a $1.0 billion post-money valuation ($100 million divided by 10%). What these articles overlook is the preference of the Series C investors, who are buying preferred shares in the company, relative to existing investors in the company, who are holders of Series A and Series B preferred shares as well as owners of common stock. The articles thus may leave a reader thinking that all equity interests are equal, which might not be the case. Ignoring the rights and privileges of multiple preferred instruments, such as voting, tag-along, drag-along, down-round provisions, mandatory conversion rights, and protective provisions, among others, might lead to misleading indications of value for multi-tranche capital structures. Ignoring these unique rights and provisions, discussion of which is beyond the scope of this article, the primary way that individual series’ of preferred stock and common stock differ is in how they are treated in a liquidity event (i.e., sale or initial public offering (IPO)).
Typically, each new round of preferred stock will have a liquidation preference at least equal to the amount invested in the round, and possibly at a multiple of that amount. This liquidation preference is usually ascribed a specified dividend return, which might be cumulative or not. This new class of equity will typically have the right to a return of contributed capital plus the accrued preferred return in the event of a sale or liquidation of the company, before any other investors have a right to share in the proceeds from such liquidation event. In the example of the $100 million Series C round, if the company is later sold for only $100 million, then all $100 million of proceeds will go to the Series C investors and nothing will be left over for junior classes of equity. This is illustrated in Figures 1 and 2, which show how proceeds would be allocated for a hypothetical capital structure at different sale values.
Financing rounds are structured this way, among other reasons, in order to incentivize new investors to invest. The liquidation preference provides the new investors with downside protection in case the company does not perform as planned. Prior to the Series C round, the company would have raised a Series B round in the same fashion, and prior to that, a Series A round. When initially formed, the company likely only had common stock, which was issued to its founders and key employees. Assuming that a company performs well, the expectation is that the original issue price of each new class of equity will reflect an upward trend, with greater values for each new class of equity and for the company overall.
So, why do these news articles report a $1.0 billion post-money valuation resulting from the $100 million Series C financing? It is helpful now to consider a case in which the company actually sells or completes an IPO at a total company value of $1.0 billion. In such a case, and ignoring any increase in the liquidation preference from accrued and unpaid dividends as well as any other unique rights or privileges, the Series C preferred investors would have economic equivalence between taking their liquidation preference or converting to common stock and, thus, receiving their fully diluted percentage of the proceeds. This is illustrated in Figures 1 and 2. This is what happens in most of the headline-raising IPOs – all preferred shares convert into common stock, a portion of which is sold in the public offering. So long as that public offering price is above the relative preferred value of the preferred shares based on their liquidation preference, the preferred shareholders will have an economic incentive (or at least economic indifference) to convert their shares into common stock. If that price is not high enough, however, the liquidation preference (including any preferred return) would have more economic value and preferred stockholders will not be incentivized to convert to common stock.
In many cases, preferred shares also have anti-dilution provisions to protect them against the company issuing shares at a price that would be dilutive to the preferred shareholders. Such anti-dilution provisions give companies flexibility to pursue an IPO even when the price is below that which would make preferred shareholders indifferent between their liquidation preference and the IPO price. Specifically, in the case of an IPO, anti-dilution provisions may allow a company to issue more than one common share per preferred share, in a ratio that makes them economically equivalent to getting their liquidation preference.
Figure 1. Share Capitalization
This example includes a relatively simple capital structure with no options or warrants and also assumes no accrual of preferred return to preferred stockholders.
Figure 2. Allocations of Proceeds in a Sale
$ in millions
As shown in Figures 1 and 2, because of the preference of the Series C investors, at any sale value of at least $100 million and up to $1.0 billion, the Series C investors receive $100 million. At any value over $1.0 billion they will choose to convert to common stock and will receive their fully diluted share of the proceeds (10%). Equally important to note is that because of the preference of the Series C investors, and considering the secondary and tertiary preferences of the Series B and Series A investors, respectively, the holders of common stock receive less than their fully diluted ownership percentage for any sale value below $1.0 billion. At any value above $1.0 billion, all investors are economically equivalent and receive their fully diluted allocation of investment proceeds.
As illustrated here, when companies raise money through preferred stock, their various classes of equity may not have equal value. In general, there is a positive correlation between the seniority of a certain equity class and the respective value of the underlying class. Ignoring liquidity considerations, and unique protective provisions for junior equity classes, the presence of a liquidation preference for the preferred shares should make them more valuable than common shares, and it may be misguided to think of them all equally. Additionally, for non-controlling blocks of common stock, or for stock options, there is the additional consideration of a lack of marketability if the financing round is deemed to yield a value on a marketable basis.
Considerations for Total Equity Value
Based on the aforementioned example, it’s not hard to understand why the news outlets do what they do – reporting the simplified implied valuation based on the most recent round of financing. Mathematically, and economically, if the company were to turn around and sell immediately after the Series C capital raise for $1.0 billion, then the Series C investors would receive $100 million of the proceeds, and, of equal importance, the common stockholders would participate pro rata with the preferred stockholders. At that valuation, they are in fact economically equivalent because the preferred stockholders are indifferent between taking their liquidation preference ($100 million) or their pro rata share of the proceeds (their fully diluted, as converted, value) of $1.0 billion multiplied by 10%, which is also $100 million. To take this legal and economic truism and say that the company is definitely worth $1.0 billion, however, is a case of the cart leading the horse. What is known about a fundraising round is how much investors put in and the particulars of the interest they received in return. What is not known, however, is the actual total value of the company because the new investors did not purchase the entire company.
The next natural question is then: "What is the actual value of the company immediately after it completes the Series C financing round?" All that can be said for certain is that the total equity value of the company should be somewhere between $100 million and $1.0 billion, assuming there are no unique facts or circumstances to suggest the Series C preferred stock is worth anything different than the $100 million raised. This is because the Series C preferred stock would receive $100 million (the amount of their investment in the financing round) in a sale with a total company price tag anywhere in that range. When attempting to derive a value for the total equity of the company based on the price that the Series C investors were willing to pay, the default method is to use a model that gives consideration to each class of investors’ preferences (typically an option-pricing model such as Black-Scholes or Monte Carlo). Such option models require assumptions for a variety of inputs, including but not limited to i) expected holding period until a liquidity event and ii) volatility of the underlying company’s equity value. These models solve for a value of the total equity of the company that yields a value of $100 million for the Series C preferred stock. In addition to providing an implied total equity value, these models also provide implied values for all other classes of equity in the company’s capital structure based on the relative preferences of each class. Additional consideration should also be given to the relative marketability of each class of equity. In a private company, non-controlling interests are often deemed to suffer from a lack of marketability. A detailed discussion of the level of value, and the relative marketability of different classes of equity, implied by a financing round is beyond the scope of this article.
In the context of a financing round, option models are premised on the notion that each class of stock essentially represents a call option on all or a portion of the value of the total equity. Thus, the equity value of the company can be viewed as a combination of call options with strike prices based on the liquidity rights of each class of equity. In this regard, the common stock in the company has value only to the extent that, at the time of a liquidity event, the funds available for distribution are in excess of the liquidation preferences of all the preferred stock. Additionally, within the preferred stock, as previously discussed, the Series B shares only have value if the proceeds exceed the Series C liquidation preference, and the Series A shares only have value if the proceeds exceed the Series C and Series B preferences. Additionally, for the preferred stock, the option model considers the fact that holders of preferred stock effectively have two options: The first is associated with the value they would receive in a liquidation, and the second is associated with the value they would receive upon conversion to common stock.
Accordingly, in solving for a $100 million Series C value, the model would produce a total equity value that would yield $100 million for the Series C shares, which would be broken down into its two options. Part of the $100 million would come from the option value associated with the option to convert to common stock, and the remainder would come from the option value associated with the liquidation preference. The option value associated with the liquidation preference is equal to the total equity value of the company less the total option value associated with each security’s option after the Series C liquidation preference (including Series C’s own option of converting to common stock). Further details of these models are beyond the scope of this article, but they can produce a value anywhere in the range of $100 million to $1.0 billion when solving for a value of $100 million for the Series C preferred stock.
The specific facts and circumstances of every individual transaction matters, and one cannot blindly apply the same model to every situation. Simply relying on the reported headline valuation could lead to a material overvaluation of junior classes of equity. Companies, shareholders, and legal counsel that are utilizing a recent round of financing to estimate the value of previously issued classes of equity need to take caution and properly weigh all considerations, in particular the relative marketability, economic rights, preferences, and incentives of each class of stock.
- Note that this article assumes that the Series C financing round is completed, at least in part, by new investors to the company as opposed to solely by existing investors from prior financing rounds. If only existing investors, and no new outside investors, participate in the latest financing round, it might be more challenging to infer an appropriate equity value indication, as this may not be considered an arm’s-length, third-party, transaction, but instead as an additional capital commitment from existing shareholders. It is particularly difficult to infer much from a capital raise in which all existing investors participate pro rata, such that all investors maintain the same overall percentage interest as before the financing round.
- For simplicity, this article ignores traditional stock options and warrants, and convertible debt.