NEIL J. BEATON, CPA/ABV, CFA, ASA, is a nationally known business valuation expert and speaker on the valuation of early stage companies. He is the National Partner in Charge of Valuation Services for Grant Thornton, LLP, an international audit, tax, and financial advisory services firm. He has more than twenty-seven years of professional experience and is a recognized expert witness in state and federal courts as well as international tribunals. He has authored an AICPA publication on valuing stock options and intangible assets for financial reporting purposes.

Preface ix

Acknowledgments xi

About the Author xiii

CHAPTER 1 Laying the Foundation 1

A Unique Landscape 1

An Overview of the Venture Capital Industry 8

Conclusion 14

CHAPTER 2 Understanding Early Stage Preferred Stock Rights 17

Stock Rights 19

Contractual Rights 28

Conclusion 32

CHAPTER 3 Enterprise Valuation Approaches 35

Relevancy of Traditional Valuation Approaches 35

Cost Approach 40

Market Approach 43

Income Approach 45

"Vectoring" Valuation Approach 46

The Income Approach as an Oxymoron 53

Conclusion 58

CHAPTER 4 Application of the Option-Pricing Method in Allocating Enterprise Value 59

Important Assumptions Underlying the Option-Pricing Model 61

Option-Pricing Method Steps in Application 66

Other Considerations in the Option-Pricing Method 86

Pros and Cons of the Option-Pricing Model 87

Conclusion 88

CHAPTER 5 Application of the Probability-Weighted Expected Returns Method in Allocating Enterprise Value 89

Illustration of the PWERM 90

PWERM Critical Assumptions 94

Overview of Stock Rights 96

Identification of Outcomes 98

Updating PWERM Analyses 104

Conclusion 105

CHAPTER 6 Applicable Discounts for Early Stage Companies 107

Basis of Discounts 108

Suggested "Corrections" to the Current Use of Put Models for Quantifying DLOMs 114

Dilution Discount 119

The Likelihood of Liquidity 120

Conclusion 123

CHAPTER 7 Advanced Valuation Topics for Early Stage Companies 125

Utilizing the OPM as a "Valuation" Methodology 127

Sequential and Compound Options 127

Allocating the Residual Value 131

Further Extensions for Compound Options 137

Venture Capital Rates of Return 139

Executive Stock Compensation 143

Conclusion 143

APPENDIX A Allocation of Enterprise Value Using the Option-Pricing Method: Treatment of Derivatives on Common Stock 145

APPENDIX B Volatility in the Option-Pricing Model 155

Notes 175

Index 179