Valuation of Private Securities: The Way the Pros Handle It

In a recent opinion by Vice Chancellor Laster in the Delaware Chancery Court, he made the point, and I quote from an Orrick alert. [1]

“Among other things the Court found that the valuation firm … did not perform a comparable companies analysis even though only months before, during the ordinary course work, it deemed another transaction in fact to be comparable.”

The securities in question had been extensively analyzed as to valuation by various professionals who had focused on methods such as discounted cash flow (“DCF”), which entails an estimate of future cash flow and then discounting the number back to the present time to arrive at a valuation. And, of course, there are a number of other methods for valuing illiquid property and, in particular, securities in a company which are not traded on an exchange. [2] The problem with DCF and like valuation methodologies is that one can arrive at just about any number which is this side of the absurd, depending on how the various elements of the methodology are tweaked.

For example, in a situation in which I participated as counsel several years ago, each side had hired an internationally recognized valuation service to compute the value of the stock in the company which an individual (who was a good or bad leaver, depending on how you looked at his performance) had owned. The valuation expert retained by the company which was paying for the shares in accordance with a put/call agreement entered into when the individual joined the company came up with a valuation of $160,000. A well-known expert, which the former executive had retained, came up with a valuation in excess of $11 million. The legal fees run up while the parties went after each other, given (among other things) this disparity in opinions, were well into the seven figures because settlement negotiations were rocky from the start.

The second reason that comparables are used so frequently is my experience in the venture capital business. The fact is the way the VCs often arrive at a valuation when making, say, the Series A investment is best described as the herd instinct. The investment managers, the members of the general partner, will look at a company in the same line of business and in the same general location and their first question is, “How did Greylock or Sutter Hill value this other company?” With that information under their belts, the answer as to the ultimate valuation is tweaked in accordance with a comparison of the size and profitability of the two companies. And what counts is the comparable information.

It is available through VC Experts on a quarter by quarter basis, one can track, for example, pre- and post-money values of medical device companies in New England over the last seven quarters. That’s the kind of information the pros very much want to review when they approach this critical inquiry. It doesn’t mean they won’t use other methods as well; but comparables are the way at least to smoke out bizarre results such as the ones in the example above cited.

[1] Halper & Rooney, “Flawed Valuation Leads Delaware Court to Award Damages to Option Holders,” Orrick, Client Alert, 08/14/2015.

[2] Disclosure: I am the chairman of the Board and co-founder of VC Experts (www.vcexperts.com) which provides officially derived comparable valuations with respect to which investments have been made as contained on, e.g., the MoneyTree Survey..

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