March 12, 2004
Common Stock Pricing in VC
Here’s something useful on that (in)famous “rule of thumb” commonly used to price common stock in VC deals (compliments of Bart Jealous of American Appraisal Associates, Inc. bjealous@american-appraisal.com ):
“The below comes Gerry Mehm, the head of our Financial Valuaton Group in our San Francisco office. Let me know if you have any questions.
The Venture Capitalists in Silicon Valley have historically used the 10-to-1 ratio of preferred to common stock values when companies did their first round of financing. That is, money was raised by pricing the A Preferred at $1.00 per share, and options to purchase common stock would be granted to the founders and key employees with a strike price of $0.10 per share. But as the company progressed, the subsequent rounds of preferred stock are typically sold at higher prices ( $2.00, then $5.00, then $10.00, etc.), and the ratio of preferred to common would then be decreased from the 10-to-1 to 5-to-1 to 2-to-1, until the shares all had the same value at the IPO date (equal to the IPO price).
This “rule of thumb” was criticized by the SEC at the height of the high-tech IPO market in 1999. Companies were routinely required to record stock-based compensation expenses in their S-1 filings if they simply employed the rule of thumb. The analysis we performed was based on reviews of the S-1 filed at the time by comparable companies. That is, we pulled data on the capitalization history of the comps, and prepared tables showing the overall money raised, the ratio of values to money raised, and the ratio of preferred to common stock values which the SEC accepted. We then built tables showing how the client’s value would increase as more money is raised and spent on development. It was a “softer” valuation than one for a mature company with public comparables, but at the time it addressed most of the questions raised by auditors and the SEC.
The issue today would be to find good comps who have gone public recently, since the IPO market has been so weak. But I would continue to use this type of analysis rather than simply the rule of thumb you refer to.”
Best regards,
Bart Jealous
Vice President-Principal
American Appraisal Associates, Inc.