Is the common share of a start-up really worth so much?

Published on 19 Dec, 2018

In the case of early stage start-ups, valuation appraisers, using the prescribed method, always come up with a common share valuation, which is invariably far from the price that any informed investor would pay for the share; also, most of the times, the difference is beyond reconciliation.

Typically, the valuation of common shares issued by a startup is performed in the absence of reliable financial forecast and any close comparable listed company. The most recent round of preferred financing is the plinth on which the valuation of common share is built. The value of additional economic rights awarded to preferred shareholders is deducted from the price of the preferred share to arrive at the common share value. This valuation method is commonly called Back-Solve.

It is very clear that the weaker non-economic rights of common shareholders are completely ignored while valuing a common share or it is assumed that weaker non-economic rights do not warrant any valuation adjustment. It will be interesting to see how these weaker non-economic rights actually materially affect common shareholders.

Investors holding preferred shares get board seats or have board observation right; in either case, they are always updated on the direction of the business and have access to a lot of confidential information. No professional investor would invest in any venture without these rights, which means that these rights definitely carry significant value.

No common shareholder, except founder(s), has board representation or observation right. The lack of these rights puts common shareholders in a relatively disadvantageous position compared to preferred shareholders.  The current valuation methodology does not accommodate the effect of this impairment in the value of a common share.

More impairing for common shareholders is the anti-dilution right, awarded to preferred shareholders. Preferred shareholders are protected against any drop in the valuation of the business after they invest. Any down round in future can deal a lethal blow to the value of common shares.

In the situation of a down round, not just new investors are issued preferred shares at a lower price; existing preferred shareholders also receive additional shares or adjustment in the conversion ratio to protect them from value erosion.

Due to the anti-dilution right, only common shareholders absorb the impact of a business downturn, providing cushion to preferred shareholders. This asymmetric distribution of risk is not factored in the valuation methodology. The shortcoming is magnified in the valuation of early stage ventures due to the very high likelihood of negative outcomes.

Taking clue from market transactions in securities of the subject company is a prudent approach; however, not appropriately capturing difference in the rights of securities would distort the final conclusion. Thus, the preferred share price needs to be adjusted before being used as a benchmark for common share valuation.

Ideally, the price of a preferred share, without anti-dilution right and without board representation, should be used in the Back-Solve methodology to value common share. However, such security is never issued, or investors would never subscribe to such security owing to the importance of these two rights.

Nevertheless, the value of such security can be ascertained by deducting the value of anti-dilution rights and board representation from the price of a regular preferred share. Anti-dilution right provides down side protection to preferred shareholders; therefore, the right can be valued as a put option on the preferred share. Furthermore, control discount/premium studies can be used to determine the value of the right to a board seat.

More sophisticated methods such as simulations can be applied to value anti-dilution rights; however, before getting lost in mathematics, acknowledging the fact that the worth of common shares can be very low compared to preferred shares will go a long way in avoiding the mispricing of common shares.




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