The estimated term to a liquidity event employed in a private company’s 409A valuation is a highly subjective management assumption that affects the value of your common stock in two important ways. Moreover, some valuation specialists take the position that the exit term can be different depending on what page of the report you’re looking at. It’s a bit like “having your cake and eating it too.” Given that there’s limited formal guidance on the matter, it’s not surprising that diversity in practice has arisen with respect to this critical 409A assumption.
Why would a company be incentivized to have differing term assumptions in its 409A analysis? The issue stems from the term assumption’s counterbalancing effects in the option pricing model (“OPM”) relative to the discount for lack of marketability (“DLOM”). A shorter term usually results in a lower common stock value in the OPM, but also a lower DLOM. The opposite is true in that a longer term usually results in a higher common stock value in the OPM, but also a higher DLOM. Therefore, to minimize their common stock value, some companies want the best of both worlds by selecting a shorter term in the OPM but then using a longer term in the DLOM.
Let’s make this more tangible with an example:
As presented above, a longer term assumption in the OPM will typically result in a higher common stock value while a longer term in the DLOM will support a larger marketability discount. In this example, moving the term from 2.0 years to 2.5 years in both the OPM and DLOM has offsetting effects and the common stock stays the same at $0.77. However, mix-matching a shorter term in the OPM with a longer term in the DLOM will result in a more advantageous common stock conclusion of $0.75. But is this allowed by the accounting standards?
Unfortunately, there is relatively little formal guidance on this matter. The AICPA’s Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, (“Guide”) has this to say:
[F]or early-stage firms, the next round of financing may be highly uncertain. Using a term in the OPM based on the expected time to exit, including the likelihood of dissolution in the short term, while still estimating the discount for lack of marketability based on the expected time to a successful exit may provide a more representative value for common stock in situations in which the company’s ability to raise the next round of funding is highly uncertain.
The Guide seems to leave the matter open to interpretation. Per the Guide, the term assumption in an OPM analysis should reflect the expected term to a liquidity event that contemplates potential downside scenarios (i.e., a weighted-average expectation), while the term in a DLOM analysis should reflect the expected term to an actual liquidity event.
At Valuations I/O, LLC (“VIO”), it’s been our experience that audit teams have a strong preference for using a single, consistent liquidity term in both the OPM and DLOM calculations. However, in limited situations we have observed that some auditors will accept divergent term assumptions, so long as the divergence is both defendable and small, with “small” usually meaning no more than one year.
When differing terms are assumed, the specific facts and circumstances should be documented thoroughly. Given that the term assumption in an OPM should reflect a weighted-average term to a liquidity event, the company should consider if the weighted-average term to an exit is underestimated or if the expected term to a successful liquidity event assumption in the DLOM analysis is overestimated. Qualitative considerations include the company’s stage of maturity, timeline to a liquidity event, and the relative uncertainty of the path to a liquidity event. All else equal, relatively more mature companies, companies with shorter timelines to potential liquidity events, and companies with higher degrees of certainty with respect to their respective liquidity events should have smaller divergences in their term assumptions. The effect of post-IPO/SPAC lock-up periods should also be considered when modeling IPO/SPAC exit scenarios.
Company management teams are ultimately responsible for the assumptions relied upon in a valuation analysis and must be ready to defend those assumptions when subjected to review. As preparers, we have two unique ways to assist management in the process. First, we can provide guidance on industry norms and help you avoid pitfalls down the road by selecting reasonable assumptions and thoroughly documenting the supporting reasons. Second, we can discuss hot topics directly with your audit team early in the process to better understand their position and then choose an appropriate path that is agreeable to all parties.