Does Black Scholes overvalue early-stage companies?

We recently reported that option models—including the commonly used Black Scholes method—may become more common as the courts, the IRS, and the SEC increase emphasis on empirical evidence and the prevalence of fair value accounting standards (see, “Are option models the future of discounts and valuation?” in BVWire #85-2).
But, a new analysis from SVB Analytics challenges the widespread application of the Black Sholes option pricing model, at least to the valuation of early-stage, VC-backed companies. “We decided to take a harder look at the data, as it relates to venture capital-backed technology and life science companies," say James Walling and Cindy Moore of “Does Black Scholes Overvalue Early Stage Allocations?” in the current (Jan. 2010) Business Valuation Update™.

What the data shows: “The reality for early-stage companies differs materially from the model that the industry relies upon to allocate the value of companies, particularly to the common shares,” Walling says. Because many valuation practitioners and auditors apply Black Scholes as the default model, “we are concerned that the common equity of many early-stage firms has been mis-valued over time.”

We’ve posted the full article as a new free download from BVResources; pushback from the auditing and appraisal community is expected. Email your comments (anonymous or attributed) to the ‘Wire, and we’ll feature them in a future issue.

IRS ‘got it all wrong’ in calculating COC in transfer pricing case

In Veritas Software Corp. v. Comm’r, 2009 WL 4723602 (Dec. 10, 2009), a billion-dollar transfer pricing case, the expert for the Internal Revenue Service used the wrong beta, the wrong equity risk premium, the wrong risk-free rate, and the wrong growth rate in calculating the cost of capital for a large, multi-national developer and manufacturer of computer storage software. That wasn’t all: the U.S. Tax Court also found the IRS expert assumed the wrong useful life for the intangibles and he even used the wrong intangibles. “Put bluntly,” the court said, “his testimony was unsupported, unreliable, and thoroughly unconvincing.” Indeed, the expert’s only credibility consisted of his “numerous concessions and capitulations.”

By contrast, the expert for the taxpayer used an appropriate beta and ERP to calculate his discount rate, but the court adjusted his starting royalty rate as well as his “ramp-down” rate to account for the character and obsolescence of the intangibles. Read the complete digest of the Veritas Software case in the next (Feb. 2010) of the BVUpdate; the full-text of the Tax Court opinion is now available at BVLaw™.

Master the art of normalization adjustments—today!

As Veritas Software makes abundantly clear, tweaking assumptions can make the difference between a highly credible valuation—and one that falls far short of convincing. Adjusting income and expenses—“normalizing” financial statements—may seem basic, but they to can produce huge differences in final results.  In fact, “the failure to develop the appropriate normalizing adjustments may result in a significant overstatement or understatement of value,” say the AICPA National BV School Supplemental Materials.

Appraisers at all levels will benefit from “Mastering the Art of Normalization Adjustments”, the next in the BVR series of webcasts, featuring expert James Ewart (Dixon Hughes, PLLC) today, Wednesday, January 20. Two CPE credits are available for any one who listens in to this $99 event. Click here to register or find out more.

2010 Duff & Phelps data now available, plus bonus COC reader

In addition to its traditional 25 size categories and 8 size metrics, the 2010 Duff and Phelps Risk Premium Report includes a special update: “Problems with Cost of Capital Estimation in the Current Environment.” Plus, if you order from BVR, you will also get the new Cost of Capital Reader free, a comprehensive collection of the most important articles and presentations on the cost of capital from the past year, such as:

  • High Financial Risk Portfolio Supplement 2009 (from the 2009 Risk Premium Report);
  • Cost of Capital Estimation in the Current Distressed Environment;
  • Top Ten Issues to Note When Selecting COC Data in Volatile Times; and more…

Exclusive offer. The Cost of Capital Reader is available only from BVR; click here to pre-order your copy with the 2010 Risk Premium Report today.

IVSC plans new guidance on accounting for intangibles

The International Valuations Standards Council (IVSC) will soon be publishing revised Guidance on the valuation of intangible asset, including an identification and definition of the principal approaches and methods, according to a recent IVSC release. The objective is to reduce inconsistency among recognized techniques and terminology to promote good practice and make valuations of intangibles “more comprehensible to investors around the world,” says IVSC chair, Chris Thorne. “In light of similar concerns in the USA, the IVSC is also collaborating with the Appraisal Foundation on the development of best practice guidance on specific areas where there is currently an absence of recognized authoritative guidance, including the valuation of customer relationships and the identification and valuation of control premiums.“

Just-released whitepaper on the ‘anxious’ state of PE

2009 will likely go down in history books as one of the most difficult years for the private investment community. Deal volume has sunk to its lowest level in more than a decade. Fundraising totals are at their lowest level since 2003, and exit opportunities have become increasingly difficult to find…

So begins a new whitepaper, Private Equity in the Post-Boom Era: What Next, by Harris Smith (Grant Thornton, LLP) in conjunction with the Association for Corporate Growth. The article looks at recent changes to liquidity markets, interviews key industry experts, and analyzes data points from a number of sources (DeaLogic and Thomson Reuters), says the summary. “Through our external sources and original reporting, we discuss not only where fundraising and exit opportunities are today, but where they are heading.”

Stress levels remain high. “After investing more than $1 trillion in private equity funds in the past decade, many limited partners are now anxious about investing in the asset class,” the paper notes. “Driving much of the decrease in private equity commitments is the dramatic decrease in available funds due to losses across limited partners’ endowments and pension plan portfolios, and the need for liquidity to fund retirement and other benefits.” The anxiety may work better on the sell-side, in Grant Thornton’s view. “As the markets continue to show signs of improvement, sellers are going to jump at the chance to sell. Private equity funds and private businesses that missed their chance to sell at the height of the market have been anxiously awaiting the chance to exit their businesses.”

Clarification: SSVS-1 is binding only on AICPA members
A final note on the Devries divorce case (see BVWire #88-1 and #88-2), in which the California court discussed whether the AICPA BV standards are dispositive in determining value, Gary Gerlach (Banister Financial) writes, “SSVS-1 guidelines are not mandatory for all CPAs, just CPAs that are members of the AICPA.”  Thanks for the clarification…


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