The Jumpstart Our Business Startups (JOBS) Act is a year old and we’re still waiting to see how the U.S. Securities and Exchange Commission will implement it. In particular, it’s “crowdfunding” provisions.
The JOBS Act makes it easier for companies to sell stock to investors who are wealthy (i.e., they meet the SEC’s “accredited investor” standard) and also, potentially, to small investors. Purportedly, the delay is due to difficulty reconciling the JOBS Act with the SEC’s mission to protect investors.
No matter how the law is implemented, I have a suggestion for how to protect investors that could also help companies compete for capital; require that all companies disclose the valuation that they give themselves when they offer stock.
Valuation is occasionally cited in news reports, such as this one comparing the anticipated valuation range for an initial public offering by Alibaba Group Holdings, a Chinese Internet company, to Facebook’s.
Facebook's IPO valued the company at $104 billion (its market capitalization has since slipped back to $63 billion). Estimates of the likely valuation of Alibaba range from $55 billion to more than $120 billion.
Many investors are unsure what valuation means. It is simply the price to buy the entire company, based on the latest price shares are sold at. When new shares are sold by an issuer, valuation refers to the “pre-money valuation”. After the offering is complete (i.e., the money is collected and shares issued), it refers to “post-money valuation” or market capitalization.
Some investors know what pre-money valuation means but are unsure how to calculate it. Here’s one way.
Pre-Money Valuation = Shares Outstanding Before the Offering X Price of a New Share
For example, suppose ABC Company has 10 million shares outstanding and plans to issue 1 million new shares at $5.00 per share to raise $5 million. With these terms, the ABC gives itself a $50 million valuation (e.g., 10 million X $5.00).
Here is the relationship between ABC’s pre-money and post-money valuation.
$50 million is ABC’s “Pre-money” valuation (10 million shares X $5.00 per share)
+ 5 million is the “Money” raised in the offering (1 million shares X $5.00 per share)
= $55 million is ABC’s “Post-money” valuation (11 million shares X $5.00 per share)
After the offering, if someone sells a share of ABC stock for $6.00, the company’s valuation—its market capitalization—will rise from $55 million to $66 million (11 million shares X $6.00). Conversely, if the most recent share price is $4.00, ABC’s valuation falls to $44 million (11 million shares X $4.00). Whether ABC is privately held or publicly traded, the calculation assumes that stock is sold at market value and that the latest price is the value of each share outstanding. Theoretically, it is what someone would pay to buy the entire company.
So, in setting its terms, ABC suggests that it is worth $50 million.
Maybe it is. Maybe it’s isn’t.
How might investors evaluate the price?
When investors know ABC’s valuation, it is easy for them pose a fundamental question. "ABC has less than $1 million in revenue and no profit. Why should I invest when it is valued at $50 million?"
When investors do not know ABC’s valuation, the pricing question will likely be "Why should I invest when it is $5.00 per share?" However, this is not meaningful; ABC could have the same valuation with a lower price and more shares.
The important price question is “Why is ABC worth $50 million?” This question is especially critical when an issuer is private—the kind of company the JOBS Act is designed for—because its stock does not trade in a market.
Valuation is important information and investors should not, as they do now, have the burden of calculating it. Some may not know how to. Others may be uncomfortable doing so or forget to. Some will calculate it incorrectly.
For venture capitalists, valuation is the most important consideration when evaluating an investment. Yes, they must feel that
Valuation disclosure will help data aggregators assemble valuation statistics for investors and companies that improve the efficiency in capital markets the same way that Kelly Blue Book improves efficiency in the car market and home listing data improves efficiency in the real estate market.
I also suggest that the SEC requires issuers to discuss factors they considered as they set their valuation and, perhaps, encourage them to suggest why the figure is appropriate. This would set the stage for issuers to compete for investors like merchants do for customers. Some may view this is as undignified, but this is what happens when markets are efficient.
Two negative consequences result from the present lack of a disclosure requirement: unsophisticated investors are more likely invest unwisely, and, issuers are less likely to compete for investors by offering better terms.
I know accredited investors who are uncomfortable calculating valuation and I am certain that most small investors would struggle if asked to. Some believe, mistakenly, that securities agencies “approve” an issuer’s valuation.
Fact is, valuation is caveat emptor—buyer beware. Undoubtedly, more investors have lost more money because they overpaid for a stock than has been lost due to fraud. Valuation-unaware investors fuel valuation bubbles—they are more susceptible to “irrational exuberance”.
Interestingly, entrepreneurs can be hurt by valuation-unaware investors too. Success at raising capital at a too-high valuation encourages them to be arrogant about OPM—Other People’s Money—and/or naïve about future raises of capital.
The second negative consequence of the absence of a valuation disclosure requirement is weak competition for investors. Issuers are disinclined to compete on the basis of valuation because many investors don’t know what it is. Plus, their legal counsel will advise them to not disclose valuation in offering documents because; a) it is not required, and b) disgruntled investors who sue may argue the company represented itself as being “worth” the valuation.
The result is that the market for equity capital is far less efficient than many other markets.
Grocery stores offer another analogy. Unit pricing helps shoppers evaluate and compare products. Where it’s not present, shoppers must calculate price per pound, per ounce, etc. Some maybe too busy or uncomfortable to do so.
Nutritional Fact Panels take the analogy further. The disclosure of fiber, salt, sugar and fat in a serving encourages informed shopping, and, it encourages manufacturers to offer healthier products. It helps small companies compete against large ones with better known brands or aisle placement.
Similar dynamics are possible in equity securities.
Two things seem true. Implementation of the JOBS Act will encourage more companies to offer stock to a larger pool of valuation-unaware investors, and, markets enhance the quality of products when relevant information is readily available to buyers.
Valuation disclosure may sound esoteric, but it’s not. The SEC requires issuers to disclose
A requirement for valuation disclosure could be accomplished on one page and it would do more, I suspect, to protect investors. It would also enhance competition in the equity capital market—whether crowdfunded or not.
Karl M Sjogren is a consulting
