Today, Vijay discovers the value of a napkin.  Thanks Anita.

I just got a call from Morgan Stanley.  Apparently the account that I have there – which has a P.O. Box as an address – now needs a non-P.O. Box mailing address.  According to the account service rep that I talked to, this is due to the Patriot Act.

Now – here’s the conundrum.  I do not have a “non P.O. Box address”.  While my house theoretically has an address, the USPS will not deliver mail to me since I live behind gate at the back end of a state park and they won’t deliver mail to me.  If one sends mail to my home address, it ends up at the post office where I have my P.O. Box, at which point the postmistress stamps it with a message that says something like “Not A Valid Address” and returns the mail (ok – sometimes she breaks the rules – she likes us – but we still get the stamp.)

It’s crazy – the government now insists on a physical address for mail, bypassing a federal institution (the Post Office).  However, the federal institution (the Post Office) considers my physical address invalid and rejects the mail.  The Patriot Act has created an infinite loop for me!  Of course, being a good nerd I figured out a solution to this problem, but I’m not sharing it just in case someone from the government (or something the Patriot Act is supposed to protect us against) is reading this.

I’ve been closely watching the saga of AOL’s dance with Microsoft and Google as it’s akin to seeing an aging quarterback take the field during the playoffs and charge down the field one last time (sorry for the football analogy – there was a lot of it on TV yesterday.)  As the clock on this deal runs out, it looks like the deal is going to go to Google.  The best analysis of this – by far – is from the Googlepark episode “The Battle for AOL.”

In case you were wondering about the new category “AGILEAMY”, it’s for news and thoughts on the following companies: Aol, Google, Iac, Liberty, Ebay, Amazon, Microsoft, Yahoo.  I figured this was an acronym that could actually be pronounced (vs. GAAMEILY or YIEMALAG) – plus it’s named after my wife. 

Alan Shimel has a good post on a recent release of a formerly “open source” product called Nessus.  With the version 3.0 release, the authors abandoned the GPL license and effectively made it closed source.  While one can debate the rationale of the parties all day long, the fundamental issue surrounding the migration of “successful” open source projects to “closed source” as part of a commercialization phase is one that I think both vendors and customers be thrashing around with for a while. 

Recently, I’ve been exploring some thoughts with my former doctoral advisor Eric von Hippel on the broader issues surrounding Free / Open Source software.  There’s been a flurry of academic research in this arena that is covered nicely in Perspectives on Free and Open Source Software (co-edited by Karim Lakhani, one of Eric’s current students.)  My simpleminded conclusion is that there is an enormous amount of complexity around this issue, especially when you incorporate our completely busted software patent system into the mix.  While it’s easy to blow this off as something that will sort itself out, I don’t think it will and we’ll be living with the dynamics of the F/OSS ecosystem for a long time.

While we’ll be spending plenty of time talking about 409A in the abstract, Jason and I thought we’d give you a real life example of the analysis for one of our portfolio companies. Following is the essence of an email I received from one of my colleagues last week about a company of his that went through a formal valuation process for 409A.

For those of you who have portfolio companies going through an external valuation analysis as a solution to 409A, we are just completing the process with Company X and wanted to let you know about some of the issues that you may want to be aware of. While the analysis still has not been finalized, the price per share that was determined by the external consultant went from $0.43 after the first iteration, down to $0.10 in the most recent turn. Clearly this process is as much art as science and can have a meaningful impact to both the company as a whole and the individual shareholders. With respect to the analysis:

• The valuation consultant used the AICPA guidelines from the practice aid called “Valuation of Privately-Held-Company Equity Securities Issued as Compensation” as the template for their analysis.
• The analysis uses a basic DCF model to determine the enterprise value, and then Black-Scholes to derive the option value of common shares.

As a result, even if the enterprise value is determined to be less than the liquidation preferences, common shares can be assigned significant value due to this valuation methodology.  While the most obvious issue is getting the DCF model correct (e.g. discount rate, exit value, etc) some other big levers that changed the valuation for $0.43 to $0.10 were:

• The valuation company did not take into account properly the liquidation structure; in particular, they did not realize Company X Series A shares were participating preferred.
• A very high volatility coefficient was used as part of the Black Scholes model, thus dramatically increasing the option value of the common shares.
• The valuation company did not properly model the debt.

The difference between the initial valuation for common shares of $0.43 and the final valuation of $0.10 is obviously very significant.  While I’m sure the valuation consultant “appreciated” the help, in a perfect world it shouldn’t be necessary.  However, we clearly aren’t living in a perfect world, especially when it comes to 409A.

In the category of “duh – that’s been there for a while”, I got a nice tip from TheOfficeWeblog about Outlook’s ability to automatically generate a map from an address.  As a member of the “endlessly directionally impaired” category of humans, I’m lost without either a GPS or driving directions.  Stupidly, my VW Touareg doesn’t have a GPS in it and even though Garmin could make my life easier, I’ve been irrationally stubborn about buying a GPS from them.  While maps.yahoo.com and maps.google.com are spiffy and nice, it’s always annoyed me that I had to enter the address manually from my address book.  Voila – go to Outlook, bring up the contact in question, and click on the little yellow arrow on the standard toolbar.  This is a simple, but nice, demonstration of integrating Office with a webapp.

On the heals of TypePad’s 18 hour outage this week, there’s been (and will be) a lot of continued discussion about how to build scalable and reliable online / web-based applications.  This is not a new problem (I not so fondly remember major and systemic outages in large services such as eBay and Amazon in the late 1990’s) but it’s gotten new attention as some of the emerging applications have scaled up the point as to have an interesting numbers of regular users (e.g. – it sucks if their service goes down for more than 15 minutes).  For example, as far as I can tell, del.icio.us has been down for the last four hours (“del.icio.us is down for emergency maintenance. we’ll be back as soon possible.”) and on 12/15/05 Bloglines acknowledged that “Bloglines performance has sucked eggs lately.”

Tim Wolters – an extremely capable CTO – has an introduction to how he is approaching this at Collective Intellect.  He’s taking a page from Google’s playbook and developing a web service based on a “shared nothing architecture.”  On Friday, I had two different discussions about scalable architectures (e.g. “we’re going to scale up between 10x and 100x on a meaningful base in 2006 – here’s what we are planning”) and both included elements of what Tim is describing.

I expect we’ll hear a lot more about this in 2006 as a small percentage of the flood of web apps created in 2005 become popular enough to have real scale issues. 

You may ask yourself “why are Brad and Jason so hung up on 409A – it just seems like yet another accounting thing my CFO is going to have to deal with.”  Wrong – it’s going to impact every employee in your company that gets stock options and is something every board member and the CEO needs to understand clearly. 

We’ve been entertained several times in the past two weeks as we’ve heard stories from board meetings where outside company counsel (from reputable law firms) have said such absurd things as “don’t worry about 409A – just grant all your options as ISOs – 409A doesn’t apply to ISOs.”  We’ll explain later why this is such a stupid statement, but for now we still have some work to do to set up the plot.

If you read our first post on 409A – Government Maximus Interruptus – you know by now that if a private company doesn’t accurately value its options, there is deep doo doo for the option holder and company. We’ll save the issues related to inaccurate valuation for another post (yeah – it’s kind of hard to implictly foreshadow with stimulating topics such as 409A – limiting our ability to impress the screen writers for 24, so we’ll just be explicit.)

So how do you correctly value options in the startup world? What does the IRS think? Under 409A, the IRS says you have three choices:

1. Do it the old fashioned way (company board determines in good faith the FMV), but if an option holder gets audited and the IRS thinks the strike price is not truly FMV, then the option holder has burden of proof to show otherwise. If (when) you lose, have fun.
2. Have a person, internal to the company who has “significant knowledge and experience or training in performing similar valuations,” create a written valuation report detailing the accurate pricing of the common stock. The quotes are directly from the IRS regulation and if you can explain the parameters of “significant knowledge and experience or training in performing similar valuations“ to us, please comment freely. The big issue is no one really knows who qualifies to do the valuation and what the report should look like. Many of the finance people at the startups that I know – even the extraordinary ones – probably don’t have “significant knowledge and experience or training in performing similar valuations” and – even if they did – why would they take the risk (remember – the finance dudes are supposed to be conservative.)
   


3. Hire an independent, qualified, experienced valuation firm to create a written valuation report. Voila – the IRS and the accounting industry just helped create a new cottage industry! This is still tricky, as outside of the traditional valuation firms, it’s unclear who is qualified to perform the valuation. Furthermore, even if startups were willing and able to hire the legacy valuation companies (at $40k a pop), there aren’t enough valuation people in the world to get all of this work done in a timely matter.

The “good news” for options 2 and 3 is that if you follow the procedures correctly (whatever that means) the IRS has the burden of proof to show the valuation was “grossly unreasonable” which is an almost impossible standard to meet. So that essentially forces companies to choose one of the last two options.  However, in option 2, you have to prove that the internal person doing the valuation is “qualified”, but since the IRS hasn’t given guidelines for this, it’s a risky proposition. If the IRS decides the person isn’t qualified and/or they didn’t follow a “reasonable” methodology (again – unspecified), this makes the burden of proof in option 2 essentially sit on the company.  As a result, rational actors are going to default to option 3.

Therefore, as a result of 409A, we are now in a world where every private company that issues stock options has to get formal valuations from time to time. So what’s the big deal?

• Cost. On the high end these valuation can cost $50,000 or so. Considering that the company must value options at every grant date, this can get incredibly expensive.  We have some suggestions for how to solve this issue economically, but that’s a later post (more foreshadowing).
  


• Competency. Not wanting to be left out of the “entrepreneurial spirit of Silicon Valley,” smaller valuation companies are popping up all over the map to perform these valuations at substantial discounts to the established players. The problem is that few firms (and very few people) have a great deal of history or experience in valuing private companies, so the verdict is out whether these reports will be acceptable to the IRS should they come knocking. We are getting multiple calls a day from people wanting to perform valuations and most of them we wouldn’t trust to give us change back from a cash register. (As an aside, one of our companies recently completed a formal valuation and the valuation firm (presumably a reputable one) forgot to take into account liquidation preferences of the preferred stock when considering common stock payouts on mergers.  Once they did this, it reduced their initial valuation by 75%.  Oops.)
  


• History. The “grandfather clause” for 409A only applies to options that have vested by 12/31/04.  As a result, any option that is still unvested (or granted) after 12/31/04 has to be “fixed” (yes – another post).  Therefore, if you are a typical private company that has four year vesting on stock options, you’ve got to fix option grants that go back as far as 2001.  Groovy.
  


• Uncertainty. The big question that everyone is grappling with is what will the results be from these formal valuations? Will they be 10 times higher? Could they even be lower? No one really know the real impact of the valuations, because no one really knows how these firms will value the companies. We’ve seen a couple reports so far and in one case the price was actually lower than the company was granting at, while the other company was significantly higher. Uncertainly, however breeds nervous people.

So bottom line, startups will have to get formal valuations done on their common stock. It’s not pretty, but it’s probably here to stay. We’ve been working on a standard process for our portfolio companies and are pretty close to having one that we recommend.  Remember – we are just suggesting ideas, not providing legal advice, check with your lawyer, even if they are clueless about this stuff and – if they are – we’re happy to recommend some that we think have a clue.)

Once again JibJab absolutely nails it.  2–0–5 is perfect.