The Case for a Valuation Disclosure Requirement
The U.S. Securities and Exchange Commission can help investors protect themselves from overpriced stock deals if it requires valuation disclosure in offering documents.
Valuation is occasionally cited in news reports but many people are unsure what the word means, let alone know how to calculate one. If you are among them, check out my YouTube video Pre-Money Valuation: How to Calculate It at https://youtu.be/cc2stjvgEbE . The slide deck is here: http://bit.ly/2bU80gV
Briefly, valuation is the presumed price to buy a company, based on its stock price. When new shares are sold, savvy investors focus on the “pre-money valuation,” which is the number of shares outstanding before the offering times the price of a new share. The number is important because the buy in valuation is a key determinant of an investor’s eventual return.
Whether privately held or publicly traded, a company’s valuation should approximate what it might be acquired for. Often, it doesn’t, especially if it is a venture-stage company. Such a business is often unprofitable, has questionable prospects and will need capital from future investors to operate. A venture-stage company is difficult to value reliably.
Assume a scenario where such an enterprise, ABC Company, is raising capital at a $50 million pre-money valuation. How might an investor evaluate an investment? If she knows the valuation, she is likely to pose a question like this one.
ABC Company has modest revenue and no profit, so why should I invest when it is valued at $50 million?
If the investor does not know the valuation, she might instead ask, “Why should I invest at $X per share?” But this is not meaningful. Many combinations of share prices and shares outstanding can result in the same valuation. Both numbers are used to calculate a valuation, just as two hands are used to make a clap.
The key question is “Why is ABC Company worth $50 million?” and investors who fail to ask it are more likely to make a poor decision, even when they are right about the company’s ability to achieve its potential. That’s because one can overpay for a position in a successful company.
Valuation is a vital data point and investors should not, as they do now, have the burden of calculating it. Many do not know how to. Others may be uncomfortable doing so or forget to. Some may calculate it incorrectly. But if the amount is declared in an offering document, anyone can see what it is.
But the SEC does not require valuation disclosure. It assumes that investors can and will calculate it themselves. This is remarkable, given how important the figure is and how likely it is that an investor will fail to correctly calculate it. It is also odd, when one considers how many pages of an offering document are devoted to risk factors while a valuation can be expressed in a single sentence.
Venture capital and private equity firms absolutely know the valuation of companies they invest in. They also have insight on comparable valuations via their network and fee-based research services that rely on voluntary disclosure from private companies. Angel investors tend to know a company’s valuation but have less market insight than VC and PE firms. In stark contrast, only a small fraction of a company’s public investors is likely to know it’s valuation and few of them will know how it compares. This is not the hallmark of a healthy, open market.
The beneficiaries of a valuation disclosure requirement will be numerous. That’s because data aggregation services can be counted on to harvest data points about private and public offerings from the regulatory database and use it to create rich content. For example, valuations could be associated with the amount raised and when, with an issuer’s industry, location, financial data and other factors. Such insight can enhance capital markets in ways that Zillow and Trulia benefit the real estate market.
Together, an issuer’s valuation disclosure and access to robust market data will position any investor, not just the professional ones, to ask questions such as these.
• ABC Company appears to be like XYZ Company, which was recently valued at $40 million. What makes ABC worth $50 million?
• The average valuation for companies at ABC’s stage of development is significantly different; what explains that?
• ABC’s valuation is comparable to companies with backing from major VCs. Given that ABC doesn’t have such support, shouldn’t it be lower?
Such data can help companies avoid the problems of raising capital at excessive valuations. Doing so encourages arrogance about Other People’s Money and naïveté about future raises of capital. The effects of either is bad and painful to recover from.
Companies that offer a below-market deal will benefit because more investors will recognize that one is offered. The data will also help investors evaluate an issuer’s valuation trend; to compare its IPO valuation to what it was in its pre-IPO offerings. A likely result of such analysis will be realization that much of the appreciation may not be explained by better performance or reduced risk but instead, by the notion that public investors should pay (a lot) more than private investors. That presumption is sure to be challenged as public investors wise up.
Valuation disclosure sets the stage for these all these things to happen. Issuers will feel compelled to compete for investors, much like merchants do for customers. Some in the investment business will scorn this prospect. It erodes the influence of clubby networks and seems, well, undignified. But competition is the cornerstone of capitalism and economies are more vibrant when they are as open as a bazaar.
Some believe, mistakenly, that the SEC approves an issuer’s valuation. It doesn’t. Rather, the agency assesses whether an issuer complies with disclosure requirements that caution caveat emptor. A buyer beware tone makes sense, especially for valuation, because there is no reliable way to assess what one should be. Besides, in a market economy, prices are set in the market. But a Don’t Ask, Don’t Tell position does not make sense. If one doesn’t know what valuation it is, how can it possibly be judged?
There is a clear role here for government, the SEC, to promote transparency and competition.
Absent a regulatory requirement, valuation disclosure will not be commonplace. Attorneys will advise issuers to not do it, citing concern that disgruntled investors might later argue the company represented itself as being worth the valuation. An undaunted CEO will find the task more complex than just providing the figure because the prospectus will also need to explain what valuation is. The following concept formula summarizes why government is needed.
Buyers in most markets — housing, clothing, food, etc. — know that there can a difference between price and worth. Such items have utility, so it is easy to judge worth. It is harder to evaluate a price for something that do not have utility, like a stock. That’s because it’s hard for anyone to know what one is worth. Those who are valuation unaware are further disadvantaged in making a judgment — they do not know the “real” price.
Grocery stores demonstrate the potential benefit of valuation disclosure. Unit pricing helps shoppers evaluate and compare products. When it’s not present, they must calculate the price per pound, per ounce, etc. Many don’t because they are hurried or uncomfortable to doing so. Absent unit pricing, food companies compete based on brand, advertising, packaging and shelf position. With it, there is more emphasis on value for the price. Nutritional fact panels take the analogy further. Disclosure of ingredients and nutritional information encourages manufacturers to offer healthier foods. Similar dynamics are possible in the market for equity securities.
Skeptics of a valuation disclosure requirement might consider that more money has undoubtedly been lost by investors who overpaid for a stock than by fraud, which is a focus of regulators. Also, that investors who are not valuation aware are more susceptible to behavior that former U.S. Federal Reserve Chairman Alan Greenspan dubbed “irrational exuberance.” In an online post, one investment advisor shared this humorous illustration of it:
At the height of the dot-com boom, the stock of the stodgy Computer Literacy Inc. rose by 33% in a single day simply by changing their name to ‘fatbrain.com.’
Funnier still is the tale of Mannatech, Inc., whose shares shot up 368% in the first two days following the initial public offering. Tech-crazed investors were keen to invest in anything to do with the internet and a company called Mannatech certainly sounded like it fit the bill.
The only problem was that Mannatech makes laxatives.
The SEC’s present position on valuation disclosure (i.e., no requirement to disclose) does nothing to inhibit such behavior. Consider the world’s largest IPO ever: the Alibaba Group raised $25 billion at an astronomical $170 billion valuation. The valuation references in its 2014 prospectus essentially say this:
Prior to this offering, there has been no public market for our [Alibaba’s] shares. The public offering price has been determined by negotiation among us and the underwriters based upon several factors.
Well, golly gee-whiz! Knock me over with a feather! That’s such a meaningful bit of information! Seriously, if that’s what will be said about a valuation — and it typically is — why bother saying anything?
Implicitly, Alibaba, like other issuers that similarly describe how their IPO price is set (i.e., virtually all of them), ask investors to view the matter as if it were the birth of Athena, the goddess of wisdom in Greek mythology.
Rather than emerging as an infant from a womb, she was born fully formed, as an adult, springing out from the head of her father, Zeus. Perhaps it is not coincidental that Athena is also associated with purity, for she remained sexually chaste.
IPO issuers who make such pronouncements suggest that wisdom and purity guide where their valuation is set.
The wisdom comes from its management and their investment bankers.
Purity is evoked in a virginal sense: the issuer’s valuation is untested in the public market. So, goodness! Who can possibly know whether the one at IPO makes sense?
Of course, these factors are based on myth, just as Athena herself.
Greed has at least as much sway on the setting of a valuation as wisdom. And all companies have a valuation history. Why it should be considered irrelevant to public investors is a curious matter. After all, private investors routinely consider what a company’s valuation trend is.
My point is that it is a challenge is to assess what a business may be worth but wrong-headed for regulators to not require every issuer to be transparent on what their valuation is and, for that matter, what led management to set it where it did.
The most straightforward explanation for why the SEC does not require valuation disclosure is that its staff does not see it as an issue. After all, an investor just needs to pull two numbers out of the offering document and multiply them. But, this logic is at odds with lessons learned about pricing from grocery stores. Furthermore, one would think than the agency whose motto is “the investor’s advocate” would embrace approaches that help investors make more prudent decisions and to attract better deals.
It could be also that no one has promoted the idea enough. In a moment, I’ll tell you how you can help change that.
It is also possible that the reason is more complex and less benign. That The-Way-Things-Work against the interests of average investors — those who are at the bottom of the capital market food chain. Here are two things to consider:
1. Public investors are bifurcated into two groups. Those who get IPO allocations are the best customers of the underwriters or those with economic and political influence. Many of them flip their shares to secondary market investors at a higher price. Thus, they are not long-term investors and they are unlikely to see a problem with the Way-Things-Work. The second group is made up of average investors who compete for shares in the secondary market. They tend to be buy-and-hold investors. Since they bid prices up, it appears that there is no reason to change anything; there is no need to make valuation more transparent. But the fact that, in retrospect, many IPO valuations are excessive belies that conclusion. I ordinarily eschew conspiracy theories but I see opposition to valuation disclosure as support for a system that disadvantages average investors.
2. Several regulatory agencies are self-funded, at least in part. They include the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency. The SEC is not self-funded; all the money it generates from fees and fines go to the general treasury. That makes it wholly dependent on the Congress for its annual appropriations. This is not happenstance. It enables politicians to leverage their influence over the SEC to raise money for their re-election campaigns. The financial services industry is likely to oppose valuation disclosure because it threatens the business model of its most powerful members. If more investors are valuation savvy; they may be less eager to buy shares in the secondary market from those who get IPO allocations. Thus, lobbyists are likely to discourage legislative support for valuation disclosure.
The possible reasons why valuation isn’t a required disclosure now are interesting. What’s important, however, is that you and a few thousand others can help change that.
Let your senators and congressional representative know that you want them to support the concept. Email the SEC chairman, Jay Clayton, at email@example.com and urge him to take the issue up for study. Here’s a message that you might use:
Dear Chairman Clayton,
I understand that the SEC does not require issuers of equity securities to make prominent disclosure in offering documents of the valuation that they give themselves. I urge you to change this. I hope the commission will make the following a required disclosure for both private and public offerings:
· The so-called pre-money valuation; and;
· Discussion of factors that were considered when setting it.
I support initiatives that encourage market forces to improve investor protections. If the SEC requires this disclosure, more companies may compete for investors by offering lower valuations and other favorable terms.
Seriously, if you want to see the ball advanced on this issue, do it! Members of the Congress are highly sensitive to what their constituents say. The SEC is similarly receptive to input from the public.
You have the power to influence whether valuation disclosure is seriously considered. It takes no money. It just requires that you to take a moment to express your support for it and ask others to do the same.
Karl M. Sjogren is the author of a forthcoming book called “The Fairshare Model, a performance-based capital structure for companies that raise venture capital via a public offering.”
It will be published about five months after 250 people pre-order a copy from Inkshares, a publisher that relies on reader support to decide what to publish.
Preview it and place a pre-order at https://www.inkshares.com/projects/the-fairshare-model
Readers who enjoy this article may find this of interest as well: A 2:3 Paradigm for Investor Risk in Venture-Stage Companies https://www.linkedin.com/pulse/23-paradigm-investor-risk-venture-stage-companies-karl-sjogren
 Some states use their “Blue Sky” laws to evaluate an issuer’s valuation, but, they lack authority over offerings that are registered with the SEC.