As we often value businesses’ common stock for Section 409A purposes, we frequently are asked, “Why is there a difference between a company’s post-money value (based on a recent round of financing) and the company’s fair market value?” A post-money value calculation simply multiplies the per-share issue price of the most recently-issued security by the total number of shares outstanding. For this total to be equal to fair market value, the value of every security would have to be equivalent, i.e., the common shares would have to have the same value as the most senior of the preferred securities. In almost all situations, this is very unlikely. The preferred securities will (almost always) be more valuable because they have liquidity preferences and may or may not have other rights and privileges, such as anti-dilution and participation rights, to name a couple.
When determining the value of a company’s common stock for 409A purposes, appraisers typically use an option-pricing model, which is a Black Scholes-based model, in order to quantify the differences in the values of the various securities. The model assumes an infinite number of hypothetical liquidation scenarios and takes into consideration the liquidation preferences, and any additional rights, of the preferred securities. The model allocates the company’s equity value, assigning relative values based on the various securities’ priority in liquidation and based on when and how much is received by them in an exit event. The effect of this is to lower the value of the common stock, which will also lower the value of the company in its entirety.
Not only are fair market value and post-money value different, the degree as to how much they are different depends on several factors, which generally relate to how onerous are the rights and privileges of the preferred. The following are factors that can affect the per-share value of the common, relative to that of the preferred:
- Are the preferred “participating preferred” and, if so, do they carry multiple preferences?
- Are the preferred accruing dividends and, if so, at what percentage?
- Do the preferred have anti-dilution provisions?
We often see companies attempt to mask a down round by issuing a new security at a higher per-share price, but with such onerous rights and privileges that there is little to no risk to the purchaser(s) of the new security. When an investor insists on taking such little risk (and the company is forced to accept the investor’s offer), it is indicating that it has very little confidence in the prospects of the company. So, although the company’s post-money value will have increased, its fair market value may actually have decreased.
There is a lot more to an investment than merely the per-share price of the security issued. Make sure that you understand all the terms and conditions of the security when you are evaluating a potential financing.
