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January 19, 2007 Thoughts 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...
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Comments
Hi Brett,
Your comments re: PWERM are interesting. Interestingly enough, there was a presentation at the Austin conference by a large, Seattle-based valuation firm that presented PWERM as being the best option for later-stage companies, while OPM was recommended for mid to late-stage.
Re: OPM, I would hope volatilities employed in the OPM would be as defensible as any other number in the valuation.
Anyhow, I do agree that PWERM would be preferable in most situations (for early stage cos), but our challenge here (in Austin) is trying to do these 409As within a budget that the market's willing to pay. Are you finding that PWERM takes more or less time to employ than OPM? Also, are you finding PWERM easier to explain to clients over the OPM? I'm getting lots of glazed looks when talking about OPM....
Posted by: Shari | January 27, 2007 12:58 PM
Thanks for your comment. We find that substantiating the volatility for OPM can be one of the more challenging numbers to defend. Especially, when you consider making adjustments for volatility on a quarterly basis over a three to five year time frame. PWERM is definitely easier to conceptualize for both clients and reviewers (Audit Partners, Tax Attorneys, and the SEC). In terms of cost, "cash is king" for these emerging companies, yet an indefensible valuation is probably worthless...figuring out how to make this process effecient for everyone is definitely a challenge.
Posted by: Brett Suchor | January 29, 2007 03:39 PM
Although PWERM seems to be (theoretically) the best method to adopt for Early stage companies, the subjectiveness of some of the inputs involved in developing the model(For eg possible Exit date,Expected Valuation at that time point etc..) might be difficult to justify as compared to volatility estimates( Which I accept is another "dificult-to-justify" estimate).Given the breadth of subjective inputs...I would like your opinion on the chances of justifying both of these methods...
On another front, I believe valuing a start-up company is more of an art than science (And their are lots of subjectivities involved throughout the valuation process)....Given these uncertainties, What is your take on taking the recent postmoney valuation as the most objective Valuation estimate avilable for a certain company?
Posted by: Vinod | March 6, 2007 09:27 AM
Thanks for your comment. I agree that justifying the inputs can be difficult in both cases. We find the volatility measure in the OPM method to be a difficult as I posted in my above comment. In both cases you need to defend an exit value. To date we have been more comfortable adjusting value based on the different probabilities or exit (PWERM) versus a calculated volatility number (OPM).
In terms of the postmoney valuation, it is an excellent determination of the value of the preferred stock as of the date. However, the leap from the postmoney valuation number to a common stock value is a wide void. Discounts are unsubstantiated and may be exceedingly difficult to defend in tax court. Large discounts also have the same difficulties with quarter over quarter adjustments as does the volatility measure in OPM.
Thanks for the comment and I would welcome any additional feedback or thoughts you may have on OPM, PWERM and postmoney values.
Posted by: Brett Suchor | March 9, 2007 12:25 PM