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Timely news, analysis, and resources for defensible valuations Vol. 16, No. 1, January 2010

Does Black Scholes Overvalue Early Stage Company Allocations?

By James Walling and Cindy Moore developed, the vast majority of options on publicly traded firms had terms of nine months or less. practitioners have adopted the Black Given that a firm is sufficiently large such that Scholes Merton pricing model (“BSOPM”) they are public, that they have sufficient trading as a method for allocating the value of a firm volume to have options trading, and have a focus amongst the various securities within a firm’s on a term of nine months or less, the likelihood . This adoption has been pro- of failure is low. Thus, a lognormal expectation moted both by its acceptance—even as a of price outcomes, with its probability of failure preferred method—by the auditing community, approaching zero, is a reasonable representation. and by its inclusion in the AICPA practice guide as an example of an acceptable method for Contrast this to an early stage, venture-backed allocating value. However, a growing group of software company where failure is the most practitioners and auditors are acknowledging the likely outcome. Further, finance professionals model’s weaknesses and indentifying a number have long known that the BSOPM overvalues of cases when its use is not appropriate. options with extended terms and that the model tends to break down for options that are deep A key underlying assumption of the BSOPM is in or out of the money. This is a function of both that the distribution of future values is a constant volatility assumption and risk free log-normally distributed. Understanding this positive drift. Valuation professionals allocating assumption, and the limitations it creates for the equity of early stage companies often use applying the model, is critical in deciding if the terms of three years or more and, depending on model is appropriate for the facts and circum- the preferred investor liquidation preferences, stances of an allocation calculation. Our recent these options are often deep out-of-the-money research into the distribution of exit values in the or in-the-money. software, medical device/equipment, and bio- pharmaceuticals industries suggests that the Early stage company prices. Much early stage exit prices are highly skewed toward failure. This pricing (defined for our purposes as the exit value data raises questions regarding the frequency of divided by the capital invested, i.e., Gross Value the industry’s use of this model. Multiples (“GVM”)) has focused in the aggre- gate to try to contrast the distribution of these Why the BSOPM works better for public vs. prices to that implied by the lognormal distribu- private companies. The BSOPM has several tion assumption underlying the BSOPM. These underlying assumptions that are typical of aca- aggregate studies have shown that a lognormal demic finance, including risk free positive drift, distribution understates the likelihood of failure no taxes, and, perhaps most importantly, a log- as well as the likelihood of a massive success. normal distribution for evolving future prices. Some practitioners have resolved this with the The model was developed for pricing options on justification: “well, they should offset each other, publicly traded firms. At the time the model was so it’s still a reasonable representation.”

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BVResources.com Does Black Scholes Overvalue Early Stage Company Allocations?

No one has done the work to figure out just what Business Valuation Update this impact is, but anecdotal evidence implies that Executive Editor: Sherrye Henry Jr. the impact is to overstate common values. Contributing Editors: Adam Manson, Further, differing industries may have differing Vanessa Pancic, Doug Twitchell exit value distributions. Consider the medical Managing Editor: David Foster device industry. A successful exit in this space Customer Service: Stephanie Crader Publisher: Doug Twitchell provides a 4-5x return to investors…and a 10x Sales and Site Licenses: Linda Mendenhall return is considered a “homerun.” Compare that President: Lucretia Lyons to the software industry, where a 10x return is a success, but “homeruns” are measured against Editorial Advisory Board the likes of Google or Microsoft. NEIL J. BEATON GILBERT E. MATTHEWS CFA CPA/ABV, CFA, ASA SUTTER SECURITIES Research and results. To try to measure the GRANT THORNTON INCORPORATED SEATTLE, WASH. SAN FRANCISCO, CALIF. degree to which a lognormal distribution is not a JOHN A. BOGDANSKI, ESQ. Z. CHRISTOPHER MERCER representative distribution, we have performed LEWIS & CLARK ASA, CFA an empirical examination of the returns to equity LAW SCHOOL MERCER CAPITAL holders in venture-financed technology and life PORTLAND, ORE. MEMPHIS, TENN. sciences firms, limiting our analysis to subsec- NANCY J. FANNON JOHN W. PORTER ASA, CPA/ABV, MCBA BAKER & BOTTS tors for software, medical devices/equipment, FANNON VALUATION GROUP HOUSTON, TX. and biopharmaceuticals. PORTLAND, ME. RONALD L. SEIGNEUR JAY E. FISHMAN MBA CPA/ABV CVA FASA, CBA SEIGNEUR GUSTAFSON As with most research in this area, getting suf- FINANCIAL RESEARCH LAKEWOOD, COLO. ficiently complete data is the greatest challenge. ASSOCIATES BRUCE SILVERSTEIN, ESQ. We selected the Dow Jones/VentureSource BALA CYNWYD, PA. YOUNG, CONAWAY, LYNNE Z. GOLD-BIKIN, ESQ. STARGATT & TAYLOR data set. Our research focused on all exits from WOLF, BLOCK, SCHORR WILMINGTON, DEL. January 2001 through January 2008 and defined & SOLIS-COHEN JEFFREY S. TARBELL NORRISTOWN, PA. an “exit” as an (IPO), a ASA, CFA LANCE S. HALL, ASA HOULIHAN LOKEY merger/acquisition (M&A), or an out-of-business FMV OPINIONS SAN FRANCISCO, CALIF. exit. It is important to note that for a significant IRVINE, CALIF. GARY R. TRUGMAN portion of M&A exits each year, the deal value is JAMES R. HITCHNER ASA, CPA/ABV, MCBA, MVS not reported. We have excluded these exits from CPA/ABV, ASA TRUGMAN VALUATION THE FINANCIAL ASSOCIATES our analysis. Specifically, for software, approxi- VALUATION GROUP PLANTATION, FLA. mately 35% of the exits were excluded; for ATLANTA, GA. KEVIN R. YEANOPLOS biopharmaceuticals, approximately 16% of the JARED KAPLAN, ESQ. CPA/ABV/CFF, ASA MCDERMOTT, WILL & EMERY BRUEGGEMAN & JOHNSON exits were excluded; and for medical equipment CHICAGO, ILL. YEANOPLOS, P.C. and device, approximately 18% of the exits were TUCSON, ARIZ. excluded. While we have excluded these due to JAMES S. RIGBY, ASA, CPA/ABV IN MEMORIAM (1946 – 2009) lack of an exit value, common sense would infer that these are mostly fire sales of assets or com- Business Valuation Update™ (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205- panies that most investors are not particularly 3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update™, Business excited to disclose. Our view is that these would Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. likely materially increase the 0-1x return segment The annual subscription price for the Business Valuation Update™ is $339. Low cost site licenses are available for those wishing to distribute the BVU to their col- of the exit data. leagues at the same address. Contact our sales department for details. Please feel free to contact us via email at [email protected], via phone at 503-291-7963, via fax at 503-291-7955 or visit our website at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. It is also likely that a small percentage of com- Please note that by submitting material to BVU, you are granting permission for the panies in the dataset have missing (unreported) newsletter to republish your material in electronic form. equity financings, or that the amount of the equity Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information pur- poses only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2009, Business Valuation Resources, LLC, (BVR). All rights reserved. No Reprinted with permissions from part of this newsletter may be reproduced without express written consent from BVR. Business Valuation Resources, LLC

2 Business Valuation Update January 2010 Figure 1

Exit Multiples: Software for Exit Years 2001-8

900Figure 1 791 Exit Years 2001-2004 800 Does Black Scholes Overvalue Early Stage Company Allocations? 700 619 Exit Years 2005-2008 Exit Multiples: Software 600 for Exit Years 2001-8

500 900 Exit Years 2001-2008 791 400 800 Exit Years 2001-2004 700 300 619 Exit Years 2005-2008 600 172 168 Figure 1 200 500 Exit Volume (# of co.'s) 104 Exit Years 2001-2008 143 90 100 400 64 69 30 39 22 18 40 21 20 41 53 0 300 200 172 168 Exit Volume (# of co.'s) 0 104 <1.0 1.0-2.0 2.0-3.0 3.0-4.0143 4.0< 100 64 69 90 30 39 Exit22 Multiple18 40 21 20 41 53 0 0 <1.0 1.0-2.0 2.0-3.0 3.0-4.0 4.0< Exit Multiple Figure 2

Figure 2

Figure 2

Figure 3

Figure 3

ReprintedConsistent with with permissions aggregate from industry Business research, Valuation our analysis Resources, suggests LLC that the underlying distribution of equity values is highly skewed toward failure for early stage technology and life January 2010 Business Valuation Update 3 sciences companies, and, as can be seen, it varies significantly by industry. Figures 4-6 below show the distribution of exits as a percent of the sample set, which is more appropriate for comparison against the typical lognormal probability density function.

Figure 4 Figure 3

Consistent with aggregate industry research, our analysis suggests that the underlying distribution of equity values is highly skewed toward failure for early stage technology and life sciences companies, and, as can be seen, it varies significantly by industry. Figures 4-6 below show the distribution of exits as a percent of the sample set, which is more appropriate for comparison against the typical lognormal probability density function.

Does Black ScholesFigure Overvalue 4 Early Stage Company Allocations?

Figure 4

Figure 5

Figure 5

Figure 5

Figure 6

Figure 6

Figure 6

ReprintedThe with difference permissions in these from distributions, Business as Valuation compared Resources, to that implied LLC by a lognormal distribution, is sufficiently pronounced to bring into question the efficacy of using the BSOPM for equity 4 Business Valuation Update January 2010 allocation for early stage companies. Equity allocation using the BSOPM for these types of companies may materially over-estimate the optionality in the common shares, and, hence, overstate their value. However, a careful look at the impact at various points on the GVM exits The difference in these distributions, as compared to that implied by a lognormal distribution, is provides some additional insights. sufficiently pronounced to bring into question the efficacy of using the BSOPM for equity allocation for early stage companies. Equity allocation using the BSOPM for these types of companies may materially over-estimate the optionality in the common shares, and, hence, overstate their value. However, a careful look at the impact at various points on the GVM exits provides some additional insights. Does Black Scholes Overvalue Early Stage Company Allocations? financing is misreported. We have not accounted the late 1970s by a group of high-powered Silicon for this, as we surmise the portion is small enough Valley lawyers as way of limiting their risk in advising that it will not materially affect our findings. clients—it had no economic basis. More recently, anecdotal evidence puts the relationship in the 1:4 Figures 1-3 show the distribution of exits based to 1:7 range, with instances outside this range not on the actual number of companies. We define unheard of. But what drives this range and relation- an “exit” as an Initial Public Offering (IPO), a ship? The distribution of exits is enlightening. merger/acquisition (M&A), or an out-of-business exit. Exit values are defined as follows: Consider the research results. A large volume of exits result in zero return to investors. In such IPO: the Company-Value-at-Exit is the pre- cases the returns to the preferred and common money value at IPO. shares are the same, so within this segment the common equals the preferred. Next, consider the M&A: the Company-Value-at-Exit is the segment where returns vary from .1x to 1x, a small amount the company was acquired for. segment at seven to fifteen percent of exits. In this segment, the preferred has value but the common Out-of-business exit: the Company-Value-at- does not, as a result of the liquidation preferences. Exit is zero. Recall that we have a large number of M&A deals without pricing (35 percent in software!). We Consistent with aggregate industry research, our would expect most of those deals to reside in analysis suggests that the underlying distribution this space, where preferred investors are getting of equity values is highly skewed toward failure some level of return and common receive little, if for early stage technology and life sciences com- any. Recent trends in liquidation preferences are panies, and, as can be seen, it varies significantly expanding this segment to as high as 3x, which by industry. Figures 4-6 show the distribution of increases this segment materially, ranging from exits as a percent of the sample set, which is 18 to 42 percent. Further, with the majority of pre- more appropriate for comparison against the ferred shares now including participation rights, typical lognormal probability density function. once the liquidation preferences are satisfied the preferred shares participate in value accretion The difference in these distributions, as com- with the common—“stealing” value and further pared to that implied by a lognormal distribution, disadvantaging the common relative to the pre- is sufficiently pronounced to bring into question ferred. In the 3x and above segment, ranging from the efficacy of using the BSOPM for equity alloca- eight to twenty seven percent, there is usually suf- tion for early stage companies. Equity allocation ficient value that the common and preferred will using the BSOPM for these types of companies be equal, as the preferred will convert to common may materially over-estimate the optionality in and receive more value than by simply taking the common shares, and, hence, overstate their their liquidation preference. However, the type of value. However, a careful look at the impact at exit becomes relevant and participating preferred various points on the GVM exits provides some often “double dip” in an M&A exit, receiving both additional insights. their liquidation preference and their participation, while in an IPO, it’s an either/or situation. Distributions and the Preferred-to-Common Ratio. Standard operating procedure in Silicon Now consider a lognormal distribution. There Valley startups until the late 1990s maintained are virtually no zero exits. Exit values depend a preferred to common ratio of 1:10, (i.e., the heavily on the current value of the company and common shares were worth ten percent of the pre- the volatility. The high volatilities of these com- ferred share value). What few people know is that panies, applied over an extended term, push this ratio was not established by valuation profes- the exit values to the 3x and above range, easily sionals or even by investors; it was established in making the common appear of similar value to

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January 2010 Business Valuation Update 5 Does Black Scholes Overvalue Early Stage Company Allocations? the preferred, unless the common is materi- Cindy Moore joined SVB Analytics as a research ally out-of-the-money at the current valuation. director in 2007. She brings more than 10 years’ Thus a lognormal distribution minimizes the zero experience in mathematical modeling and statis- value, common equals preferred segment, but tical analysis. Moore has worked for Andersen may maximize the 3x+ common equals preferred Consulting (Accenture) and the Federal Reserve segment. The relevance of the segment where Bank, as well as for software start-ups in the preferred is superior to common depends on the affinity recommendation, price optimization, and “starting point” of the valuation relative to the supply chain collaboration sectors. preference stack. This material, including without limitation to the Conclusion statistical information herein, is provided for infor- mational purposes only. The material is based in Our research shows that the actual distribu- part on information from third-party sources that tion of exit prices for early stage companies we believe to be reliable, but which have not been is materially different than the lognormal dis- independently verified by us and for this reason tribution underlying the BSOPM model that we do not represent that the information is accu- the industry relies upon. It further shows that rate or complete. The information should not be exit distributions can vary materially based on viewed as tax, investment, legal, or other advice industry. Careful consideration of these distribu- nor is it to be relied on in making an investment tions provides insight into expected preferred to or other decision. You should obtain relevant and common ratios, and the factors impacting this specific professional advice before making any relationship. These differences may skew the investment decision. results when BSOPM models are inappropriately applied. Understanding how the future distribu- tion equity values assumption performs when applied to companies at different growth stages and in different industries will help the valuation practitioner to make better informed decisions on allocation model selection and implementation.

About the Authors

James Walling is the chief operating officer for SVB Analytics, which provides solutions to analytical problems that are specific to emerg- ing growth technology, life science, and venture capital companies. In that regard, SVB Analytics is rendering valuation opinions for clients to help them comply with tax and financial reporting requirements. Walling oversees SVB Analytics’ valuations services team, which counts more than 1,100 clients to date.

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6 Business Valuation Update January 2010