eShares, the cap table management software company recently announced that they had four announcements regarding their lead gen product, also known as 409A valuations to us.
After the announcement I took the time to look into the offering and claims from them. I downloaded the open source model and sample report they made available that day. I’m taking the time to address them specifically because eShares understanding of 409A valuation, finance, and consulting puts founder and employees who work at startups at risk and I feel compelled to provide the information.
The Valuation Models They Use Are Questionable at Best
I’m starting with the first and most important, the model they “open sourced” (more on this below) is WRONG and would have RESULTED IN A CHEAP STOCK ISSUE.
After the announcement I took the time to download the model and report they provided. We took the time to run what we call “shadow” calculations on the model. Meaning we simply use the same inputs as they have, run them in our models, and see what if any differences there are. We know our models are correct as we have painstakingly vetted them. This is the same process an auditor from an accounting firm, IRS, or SEC would do as well.
The result? The last “breakpoint”, or calcuation, in the model is incorrect and as such results in a value that would have been flagged by an auditor and cost everyone money, time, penalties, etc…..you get the idea. Utilizing the same inputs here are the results:
eShares value per sommon share: $0.25
Meld Valuation value per common share: $0.27
Woops! Guess it’s not so simple after all, ugh…..Imagine a portfolio company that has a cheap stock issue and that all the employees could be personally liable for immediate taxation, plus a 20% penalty. My guess is that it would not only be hard to retain employees but to attract new ones as well.
eShares Breakpoint: The model they used is not correct and the breakpoint calculations are wrong.
The correct last breakpoint that we made resulted in a value per share that is higher and subsequently would of caused problems for the company.
For the full technical breakdown see our original post.
Experience matters. What eShares gets wrong here is that many people can do the math. That’s the easy part. There have been a number of 409a firms that have come and gone over the years and typically learn the hard lessons that its not just about doing calculations.
The hard part is being able to make sure that math matches the qualitative story for the valuation, having the quantitative tell the qualitative story. It seems based on the company communication that it’s all just math, that valuation firms keep models secret, and that by “open sourcing” the models it somehow has disrupted an industry, which seems more about Silicon Valley ego than anything else. This is like saying “Today I’m open sourcing all home construction……..here is a pickup truck full of tools”. The models are just tools, knowing how to use them and becoming a craftsman is what is important, not the tool itself.
An old boilermaker was hired to fix the steam engine of a giant ship. After arriving and listening to the engineer’s description of the problem, he asked a few questions and then checked out the boiler room. Carefully inspecting the maze of twisting pipes, feeling the pipes with his hands. He then reached into his tool bag grabbed a small hammer, and tapped once on a valve as the boiler system lurched into perfect action. A week later the steamship owner received a bill for $1,000. The ship owner complained because from the perspective of the owner the boilermaker barely did anything to fix the problem. When the owner asked to see an itemized bill, this is what the repairman sent him:
Tapping with hammer………….$0.50
Knowing where to tap………….$999.50
eShares Lack Independance and Puts Safe Harbour Into Question
The IRS has defined what it takes to be independent and you should definitely care. The guidelines require that “valuators will employ independent and objective judgment in reaching conclusions and will decide all matters on their merits, free from bias, advocacy, and conflicts of interest.” This is clearly not the case with eShares who have an economic interest in you using their cap table product, which is ultimately what they are focused on, not 409A valuations. It goes even further.
According to their web site frequently asked questions section:
Q: “Does my company need to be on eShares?”
A: “Yes. We use your eShares cap table to prepare your 409A reports.”
Does that sound independent and free of conflict of interest to you??
eShares offer a low-quality, automated valuation for next to nothing. The reason they do this is because they can make more money selling you cap table management software. So think of it as using your 409A as lead gen for their tech product.
This relationship is an obvious conflict of interest. It gets worse because eShares cannot claim that its compensation is unrelated to the use of the report. The valuation report helps eShares issue stock options. They are compensated as you use their software to issue those very options, so if challenged it could be a disaster, giant headache and distraction from your ultimate goal of building a company.
eShares Valuation Staff Does Not Meet the Criteria of "Qualified Appraisers"
I don’t want to bore you with all the minutiae but typically a Qualified appraiser “has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary”
“An appraiser will be treated as having demonstrated verifiable education and experience in valuing the type of property subject to the appraisal … if the appraiser makes a declaration in the appraisal that, because of the appraiser’s background, experience, and membership in professional associations, the appraiser is qualified to make appraisals of the type of property being valued.” Further clarified by IRS Notice 2006-96, section 3.03(3) and 3.03(3)(b)(ii).
The head of valuation services at eShares had NO 409A VALUATION EXPERIENCE prior to his position with the company. Totally up for you to decide if this is important or not but I would view this as problematic if it were me. I like to know that when I hire professionals for a service that they have experience in the field. Beyond this person best I can tell there is the CEO of eShares, which I doubt he is doing 409a valuations, not that he has the qualifications, and some interns and an analyst or two fresh out of college. Does that sound like “experience in valuing the type of property subject to the appraisal”?
My basic assumption is that they opted to pay low salaries and give equity to potential hires rather than having to incur the expense of recruiting and paying qualified senior valuation employees to fill the positions. Typically, more senior valuation professionals are expensive and have higher salary requirements, but for good reason, ibid.
I’m pointing out these issues because by ignoring them it does a disservice to the very customers that eShares is claiming to help. Yes, they are a competitor on the 409a valuation side of our business but that is a minor issue when compared with the number of people that could potentially have a problem with cheap stock. As a GP how would you feel if the company you invested in was distracted from their primary business because they were having to deal with a cheap stock issue or it was holding up an exit because the auditors found one and decided to dig in even further? These issue will and can run up and down the sprectrum from portfolio company, to fund, to GP.