Managing Compliance-Based Valuation of Start-Ups

With the advent of IRS Section 409A and the introduction of certain fair value accounting rules, valuation issues have become increasingly important for start-up companies. In the past, industry specific start-up “rules of thumb” may have been sufficient to serve as reasonable basis for any valuation concern. For example, the “Silicon Valley Rule” holds that the value of a common share is equal to 1/10 of the value of the preferred share pricing in the most recent capital round. While the simplicity of such rules can be appealing, the scrutiny of the IRS, SEC, and your auditors in combination with the potential liability associated with misreporting financial performance make it critical that value be determined and articulated in a credible fashion.

Valuation opinions of common stock are necessary to defend strike prices set for stock options and stock appreciation rights from the IRS (see Section 409A) and to measure the cost of equity compensation for financial reporting (see Standards of Financial Accounting Statement [SFAS] 123R). Valuation opinions of other equity investments are also necessary for the reporting of interim investment performance in investment fund financial statements (see SFAS 157). Whether you plan to satisfy your valuation compliance needs in-house or to seek outside services from a specialist, you need to have an informed understanding of basic valuation fundamentals related to medical device start-ups.

Getting the Value Right

Getting value “right” is important. Attorneys and accountants occasionally throw around the terms 409A and 123R connected to some vague call to action, but here is why value really matters for medical device start-ups:

• Issuing stock options with a strike price below the fair market value of the underlying stock carries significant tax penalties for the recipient, which can create distractions for start-up managers at a time when focus on the business is most important.

• Issuing stock options with a strike price significantly higher than the present value of the underlying stock undermines their usefulness as an incentive. Underwater options are less likely to provide a reward to recipients for value-creating efforts than those issued at the money, when the option strike price and the value of the underlying stock are equal.

• The IPO process is not the time to uncover problems with accounting for prior equity compensation grants.

Compliance-driven valuation, which requires consideration of common stock value from a hypothetical “value today” perspective, often requires participants in the venture capital world to consider value from a different angle. Unlike a mature, cash flow-positive business, medical device start-ups are valuable based on the prospect of proceeds from some future successful exit event, generally an IPO or strategic acquisition. Accordingly, venture capital firms and start-up company executives tend to frame their perception of common stock value from the potential date of successful exit. Historically, the concept of “value today” for common stock in a medical device start-up has been largely meaningless, because the exit date is the only date that matters to such an investor. (The investment date would also matter, but common stock generally belongs to founders and managers.)

The valuation of early-stage medical device companies is complicated by several factors:

• Investments in medical device start-up companies are largely illiquid, and there are no relevant public comparable companies to provide reasonable benchmarks in measuring value.

• There is often significant uncertainty related to the ultimate success of a medical device start-up (in terms of both product development and commercialization). Such uncertainty is inherently difficult to quantify.

• The underlying economic asset base of most medical device start-ups consists primarily of unique intellectual property and other intangible assets for which there is no active market.

• Medical device start-ups often raise capital to fund product development and commercialization through several rounds of preferred stock issuance, which creates a complex capital structure consisting of a variety of equity classes with different rights and preferences. As a result, determining the value per common share is rarely as simple as dividing total equity value by shares outstanding.

Below, we will discuss common circumstances that give rise to the need for a valuation, basic valuation concepts, and specific valuation considerations relevant to medical device start-up companies.

Defining Value

For start-ups, valuations are most often needed for employee stock option grants and related equity compensation compliance. Financial reporting rules require employers to record compensation expense equal to the fair value of the option grant as of the grant date. IRS Section 409A imposes additional income tax burdens for participants of nonqualified deferred compensation plans, (which includes stock options and stock appreciation rights issued to employees “in the money.”)

To avoid such concerns, the company must not issue options with strike prices equal to or less than the value of the underlying common stock and be able to credibly defend the stated stock value after the fact. Given the severity of the tax implications, the rule effectively requires nonpublic companies that issue stock options or other forms of equity as compensation to obtain an independent, contemporaneous valuation of the relevant securities.

Other common valuation circumstances for start-ups involve advisory services and fairness opinions related to additional fundraising or exit events. These services are on behalf of company management for both planning purposes and fulfilling a fiduciary duty to shareholders. There is also a growing trend of venture capital funds obtaining independent valuation opinions or reviews of internal valuations related to compliance in reporting fund investments at fair value. Since equity compensation issues are the most common valuation issues that face medical device start-up executives, we will frame our discussion primarily from this perspective.

Through casual observation, value seems like an easy concept with a single straightforward definition. In the context of medical device start-ups, however, the clarity of the concept of value quickly diminishes with the question: Value according to whom?

To confront this question, valuation specialists use the concept of standard of value to establish the particular definition when it’s used in a specific situation. Identification of the appropriate standard is the first step of every valuation. So, what are the most common standards for start-up companies?

Fair market value is historically the most common standard of value used in business appraisals and is the standard used for 409A compliance related to equity compensation. Fair market value is defined by Revenue Ruling 59-60 as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Note that the willing buyer and willing seller are hypothetical parties—they are not necessarily the same as the existing investors in a particular equity interest.

Accounting standards require that certain investments and equity compensation expense be measured at fair value. Similar to fair market value, fair value reflects a price in a hypothetical transaction between hypothetical parties. Start-up executives and venture fund managers often pragmatically observe that fair market value and fair value are different from the real world, where buyers and sellers are specific people who are individually motivated, uniquely informed, and are using something other than 100% cash to transact business.

Investment value is the value to a specific investor based on that person’s particular investment requirements and opportunities. This value reflects the knowledge, expectations, synergies, and economies of scale of the particular investor. Investment value is generally used when valuation or investment banking professionals are advising their clients about the merits of executing a specific transaction, such as raising additional equity capital, selling the business, or completing an IPO. Investment value answers the questions: What’s it worth to them? Or what’s it worth to me?

Potential Exit Prospects

As we have discussed previously, valuation of an interest in a medical device start-up is effectively the analytical conversion of potential exit prospects into value today. Accordingly, the value of a start-up company is ultimately a function of:

• The range of potential exit values for the company if successfully developed, or “what we will get?

• The probability of achieving a successful exit, or the odds of getting it.

• The expected time period necessary to achieve a successful exit, or the time it will take to get there.

• The expectations of future capital needs, or “what we will need to get there?”

For medical device start-ups, exit events generally take the form of a strategic acquisition or an IPO. In either case, exit value will be driven by the relevant market characteristics combined with the expected impact the company will have on that market. At any given point, the probability of achieving a successful exit—and the expected time period necessary to achieve a successful exit—will be a function of the development stage of the company and certain key indicators such as management quality.

Market Characteristics. Characteristics of the relevant market, including size, expected growth, and competitive dynamics, are perhaps collectively the most significant factor in the exit valuation of a medical device start-up. Even if a start-up has everything else in place, 100% market share of nothing is still nothing. Relevant measures in evaluating a particular medical device market often include the number of physicians performing procedures, the number of procedures performed in a given year, and the reimbursement rate per procedure.

Most new medical devices tend to be improvements on devices used in existing procedures, and thus have a readily defined market at the start of the device development process. Less frequently, new devices offer revolutionary solutions for which there are no existing markets. Developing expectations of market characteristics in this situation is more difficult, but such products typically command far greater market impact.

Market Impact. Market impact can be defined as the market share that a medical start-up would likely command if development efforts succeed. Market impact is driven by the disruptive potential of the new technology and management’s ability to develop the technology, execute the business plan, and fully realize the new technology’s disruptive potential.

Other than the disruptive potential of the new technology itself, strategic acquirers in the medical device space commonly consider a variety of factors in evaluating the potential market impact of a new device:

• Strength of intellectual property.

• Stability of design.

• Technical performance data.

• Support from animal studies.

• Support from human clinical studies.

• Completion of regulatory approvals.

• Reputation of “early-adopter” surgeons using device.

• Reliability of supply chain.

• Reliability of distribution partners.

• Availability of technical expertise (to facilitate transition after acquisition.)

Stages of Development. The value of a given start-up is largely related to its level of operational development. Most medical device start-ups tend to follow similar patterns in operational development regardless of industry segment. Loosely speaking, medical device start-ups often follow this developmental sequence:

1. Conceptual Design.

2. Market Verification.

3. Device Design Verification.

4. Regulatory Approval.

5. Human Clinical Trials.

6. Initial Product Launch.

Since the development of start-up enterprises is measured by the passing of various milestones, the meeting of milestones (or the lack thereof) contributes significantly to the valuation of a start-up. With the passing of each milestone, the level of uncertainty associated with the start-up decreases and thus drives value upwards.

Passing certain milestones creates a bigger impact on value than passing others. Examples of such milestones include the completion of the initial round of financing, proof of concept, regulatory approval, delivery of product to customers, and profitability. Also, meeting later-stage milestones generally drives greater increases in value than that of earlier-stage milestones.

Key Indicators. Compared with mature enterprises, financial information for start-up companies is less frequently available and typically of lower quality. Due to this relative lack of information, factors such as the quality of the management team, clinical advisory team, and venture capital investor group become an important consideration, especially in the valuation of early-stage start-ups.

Valuation of Equity Classes

At this point, it may be helpful to clarify the difference between valuation of an enterprise and valuation of a particular equity class. Enterprise value of a medical device start-up, i.e. the value of the overall business, is a function of, one, expectations related to total proceeds from the range of possible exit events and, two, the amount of additional capital necessary to achieve a successful exit. On the other hand, the value of a particular equity class is a function of not only expectations related to both exit proceeds and necessary capital but also of the allocation of exit proceeds across the range of possible outcomes.

In other words, the value of a particular equity class is driven by the same factors that drive enterprise value, combined with consideration of the differences in rights and preferences across classes of stock in the company’s capital structure. Accordingly, even when the subject interest of a valuation is a particular equity class, determination of enterprise value often serves as a starting point to get there.

When considering the value of a particular equity class, it is important to maintain a forward-looking perspective. A common misconception is that enterprise value should be distributed under the pay-off waterfall, as if cash proceeds equal to the indicated enterprise value were allocated today. Underwater stock options have value because of the potential for stock price appreciation before the option expires. In the same way, the common stock in a medical device start-up has “option value” when the total liquidation preference of outstanding preferred stock is greater than enterprise value (as long as the potential exit event is still some time away).

There are a variety of methods for allocating the total enterprise value to the various classes of equity. When there are no imminent prospects of a sale or IPO, the two most commonly accepted equity allocation techniques are the probability-weighted expected return method and the option-pricing method. An in-depth discussion of the application of these two methods is beyond the scope of this article, but we mention them for you to know what third-party reviewers of a valuation will be looking for.

Minimize Potential for Surprises

As you lead your medical device company, be aware of events that can potentially create the need for compliance-based valuation. Include them in discussions with your attorneys, accountants, and directors to minimize the potential for surprises. When addressing compliance-based valuation issues, maintain a “total cost” perspective over time. Shortcuts taken in the present can become expensive in terms of time, money, and distraction down the line, particularly when the IRS or SEC get involved. Take the necessary steps so that you are sure that valuation is done right the first time. Keep these things in mind and you will be well on your way to effective management of compliance-based valuation issues.

Patrick Lynch is a senior member of Mercer Capital’s Financial Reporting Valuation Group, which provides public and private clients with fair value opinions and related assistance pertaining to goodwill and other intangible assets, stock-based compensation, and illiquid financial assets. He also leads Mercer Capital’s medical device industry practice group, and is active in valuation related to start-up enterprises and early stage technology assets. Lynch can be reached via e-mail at [email protected] and can be found on Twitter at @lynchbp0.