The Pitfalls of Using Only Preferred Share Price for Common Stock Valuation

Applying fundamental valuation approaches to value an early-stage business is challenging; thus, many have abandoned them in favor of a mathematical approach called the back-solve method. The method requires less judgment on the part of appraisers; therefore, it is easy to apply. However, the method tends to overestimate business value, so ignoring fundamental approaches would lead to the wrong conclusion.

In the world of startups, it has become common practice to determine the fair market value of a common share based on the price of recently issued preferred shares. Valuation practitioners often use the Black–Scholes model, also known as the backsolve method, to derive the fair market value of common stock by adjusting for the incremental economic rights of preferred shares. However, this method, like other valuation approaches, has its own limitations, and depending solely on it may yield inaccurate results. Despite its theoretical superiority, the method overlooks non-economic parameters that drive the value of a financial instrument and blindly accepts the preferred share price as an indisputable truth.

Before using the preferred share price as an input, it is crucial to evaluate whether it truly aligns with the definition of the fair market value. The IRS defines fair market value as "the price that property would sell for on the open market." The open market operates on the principle of multiple buyers and sellers engaging in transactions. Consequently, the IRS definition can be interpreted as the price at which the property can be sold by many sellers to many buyers.

In an open market, numerous buyers and sellers participate in transactions, refining the quoted prices and offering a more accurate representation of the security's value. Conversely, a private company funding round involves a transaction between one seller and a select few buyers, resulting in a single occurrence. Therefore, pricing in the private company funding round represents the opinion of a limited group and fails to meet the criteria for fair market value.

Even in the case of a listed company, the price of a big block of shares traded infrequently would not qualify as fair market value. Hence, accepting the preferred share price in a private funding transaction as a fair market value seems an exception to the accepted rule. Furthermore, typically, before a VC agrees to invest in the venture, the company faces rejection from many other investors. So broad-based acceptability of the preferred share price is also questionable.

While VC funds are often regarded as savvy investors, there are numerous examples where prominent venture capitalists have overestimated the value of a business. Cases such as SoftBank's investment in WeWork, Theranos' USD700 million fundraising from notable VCs, and the failures of once promising ventures – such as Jawbone, Quibi, Homejoy, and Juicero – are well-documented. In summary, valuations determined by a select few individuals in a boardroom frequently fail the fair valuation test. If the preferred share price becomes the basis for valuing other securities, it is highly likely the resulting values would be inflated in most cases.

In addition to the overoptimism of venture investors, differential non-economic rights undermine the suitability of the preferred share price as a benchmark for common stock valuation. Preferred shareholders often have access to privileged information through board seats or board observer rights, which is not available to non-founder common stockholders. They also enjoy drag-along and tag-along rights, granting them control over exit opportunities.

Moreover, preferred investors often benefit from anti-dilution rights, protecting them from a drop in the business's valuation. All these additional rights associated with preferred shares render them an imperfect benchmark for common stock valuation, unless the value of these rights is adjusted before using the preferred share price as a benchmark. Unfortunately, the widely used backsolve method is incapable of factoring these superior rights awarded to preferred shares in the valuation of common stock.

Considering the limitations of the backsolve method as a valuation methodology and the preferred share price as the primary input, relying solely on them would result in an overvaluation of common stock. Therefore, it is advisable to utilize the backsolve method as one of several methodologies for common stock valuation, rather than relying exclusively on it, to determine the common stock value that can prevail in the real world.