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January 31, 2007The SEC Agrees with the Market
Brought to light in yesterdays WSJ, The Securities and Exchange Commission for the first time has blessed a method for valuing employee stock options derived from market prices rather than academic models.
Since the institution of FAS 123R, a big problem has traditionally centered around the fact that employee stock options do not resemble those that are publicly traded on common option exchanges. Most significantly, the term of the employee options may be as long as 10 years. A common flaw in the Black Scholes model is that it is best for "short-term" options, usually 1 month to less than 1 year,
like those that are publicly traded. The flaw resulted in overstated option values, which to any company's chagrin, resulted in lower reported earnings.
Last year, Zions Bancorp (ZION) addressed the problem by creating securities that mirror the stock options granted to its employees. The company then sold the securities to sophisticated investors in a public auction, deriving a market value for the options from the bidding. The buyers paid about one half the amount indicated by the Black Scholes model.
This is good news for all companies facing FAS 123R issues. How auditors interpret this news will be interesting. Many companies already create markets for their options, although they tend to be related party transactions. Now employee option grants just have to include a public auction to institutional investors. This may be a big task for the smaller cap companies, who by the way, tend to be the largest issuers of employee stock options.
January 30, 2007"Nothing has really changed..."
When meeting with management teams we often hear the phrase, "nothing has really changed". Clients are usually referring to the fact that their strategic plan hasn't changed significantly because either they are on track to meet their objectives or they might be headed sideways and haven't met their objectives. As a result it appears as though "nothing has really changed". Yet, when considering value, its important to remember that achieving and conversely missing targets impacts the risk profile of the investment. A company that has consistently met its objectives, albeit at times small objectives, is serving to reduce the perceived risk of an investment in the company and hence building value. Conversely, a company that is headed sideways and possibly simply maintaining its revenue numbers, yet failing to truly hit its targets is often proving to be a riskier investment than once thought and thus eroding value. So as we analyze how and if value is moving from quarter to quarter, its certainly rare that "nothing has really changed".
January 24, 2007Are Companies Getting Better At M&A?
I recently read an interesting report from The McKinsey Quarterly on M&A titled "Are companies getting better at M&A?". Their findings are encouraging, despite the fact that the recent M&A boom has surpassed the record levels of 2000. The study cites a couple of key points: 1) "cash deals represent a much greater percentage of the public-to-public transactions...nearly half, compared with the 1999 to 2000 range of 20 to 30 percent"; and 2) based on the metrics of their study, buyers appear to be making smarter acquisitions and are deemed to be overpaying in only about 56 percent of transactions versus 73 percent in 2000. The study is worth reviewing as it definitely highlights the changing landscape in M&A deals and is good news for buyers.
January 19, 2007Thoughts on the PWERM
This week I was in Seattle and met with the valuation group of a large accounting firm. The subject of 409A arose as it often does because of its huge impact in the valuation community. Our discussion moved to valuation approaches and we actually agreed that the Probability Expected Return Method ("PWERM") was the best approach to 409A for emerging technology companies with complex capital structures. I know you wish that you could have been in the room for such a riveting discussion. We actually talked about other crazy stuff as well, the weather, commuting, sports...
Actually a sense of relief crossed my accounting firm counterpart's face as I went into my reasoning for PWERM and he mentioned that most of the reports he reviews use the Option Pricing Model ("OPM"). We agreed that OPM can be a great solution for late stage companies, but is very difficult to scale. The option pricing model treats the value of the common stock like an option and employs the Black Scholes model, which is dependent on a volatility measure. In the end, the outcome is very sensitive to the volatility input and we both agreed that if we worked for the IRS, challenging one input (e.g. the volatility measure) would be a better fact pattern to attack than a more thorough PWERM model. In the long run, OPM is a much easier target...
January 03, 2007Running in a circle...
So much for 'private.'
The massive expansion of the private equity markets in the past two years has been fueled by a number of factors including a highly restrictive regulatory environment, cheap debt and a basic perception (and/or reality) that the market is interested in short-term rather than long-term returns. In 2006, the private equity and hedge fund markets set new records as it seems as though every company, both private and public are targets. The torch being carried by the private equity community is that we can clean up these companies, hold them for longer periods without quarterly scrutiny (e.g. KKR's average holding period is 7 years), and prepare them for a sale or a return to the public market. In fact, private equity groups are becoming in effect some of the nations largest employers. With this incredible momentum its curious why some hedge funds and private equity groups are raising capital in the public markets. The benefit of public markets is that capital is permanent and buyout firms won't have to return capital to the investors at the end of a fund's life or upon the wind down of an investment. Yet, it seems that by raising public capital to fund growth, private equity groups are chasing their tail. Welcome back to the highly regulated world that focuses on short-term versus long-term holding periods, is fraught with heavy regulation and oh by the way requires that you disclose your investment strategy...so much for 'private'.
