OpenAI and its biggest backer Microsoft (MSFT) are discussing how to divide up the spoils of the AI upstart when OpenAI becomes a for-profit company, but agreeing on a fair market value for those assets will be a tall task.
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It all depends on who is doing the math, according to legal experts.
"The issue is that there are probably 6 to 10 different ways to value a company," said Columbia University Business School professor Angela Lee. "And depending on who you ask, and my guess is, depending on which model you use, you could be off by a factor of like 3x to 5x."
Arriving at a precise valuation for the startup responsible for ChatGPT will be nearly impossible, added Case Western Reserve University corporate law professor Anat Alon-Beck.
"I suggest that any valuation in this context should be treated as a range rather than a definitive figure, given the inherent uncertainties," Alon-Beck said.
The Wall Street Journal reported earlier this month that OpenAI and Microsoft hired Wall Street investment banks Goldman Sachs (GS) and Morgan Stanley (MS) to advise them on these discussions after OpenAI closed a $6.6 billion funding round valuing it at $157 billion.
Microsoft CEO Satya Nadella, right, and OpenAI CEO Sam Altman, left, at the OpenAI DevDay event on November 06, 2023 in San Francisco. (Photo by Justin Sullivan/Getty Images) ·Justin Sullivan via Getty Images
Microsoft, among the investors in the latest funding round, has now devoted a total of nearly $14 billion to OpenAI since 2019.
The question is how much equity Microsoft should receive in a new for-profit OpenAI in exchange for that $14 billion. There are also other thorny questions about rights to future profits that need to be ironed out.
These issues are being debated while the bonds between the two companies start to show signs of wear, according to reporting in The New York Times, as financial pressures, executive exits and disagreements among employees take their toll. OpenAI expects to lose $5 billion this year, according to the Times.
OpenAI’s current implied valuation of $157 billion would put it on par with the market caps of some of America’s largest and best-known companies, including Goldman, the Wall Street giant offering OpenAI advice during the talks with Microsoft. Goldman is currently valued just north of $160 billion.
The Goldman Sachs headquarters building in Manhattan. (Photo by Spencer Platt/Getty Images) ·Spencer Platt via Getty Images
Lee said there are understandable justifications for OpenAI's $157 billion valuation, but critics could reasonably argue the figure is off base.
"When talking about hyper growth companies like Open AI, we are basing it off what it could be valued in 5 to 10 years," Lee said. "So you don't have performance. You're basing it off potential, and that's why this is so difficult."
Arguments can be made for or against a higher or lower number. On one hand, OpenAI’s in-demand industry of artificial intelligence and its meteoric pace of growth both justify pushing up its valuation, according to Lee.
On the other hand, she said, its business model hasn’t shown a path to profitability, losing roughly $1 billion per year. That, coupled with a market that’s been slow for deal making, should drive down the price, Lee added.
Alon-Beck said "information asymmetry" and legal compliance requirements to switch from a non-profit to for-profit entity also make traditional valuation techniques less reliable.
"The organization’s proprietary models, algorithms, and decision-making processes are not fully transparent to potential investors," added Alon-Beck said, and that could cause investors to overestimate or underestimate the value.
'Who's going to speak for the nonprofit?'
The reclassification to a for-profit structure would be yet another seismic shift for OpenAI, upending the way it was established nearly a decade ago.
It began in 2015 as a nonprofit under the name OpenAI Inc., a nod to its mission of advancing humanity instead of pursuing profits.
Things got more complicated in 2019 when OpenAI CEO Sam Altman and his team created a for-profit subsidiary to raise outside venture capital — including the billions from Microsoft.
It was structured in such a way that the for-profit subsidiary, technically owned by a holding company owned by OpenAI employees and investors, remained under the control of the nonprofit and its board of directors while giving its biggest backer (Microsoft) no board seats and no voting power.
The inherent tension between these two parts of the enterprise is what contributed to a dramatic boardroom clash in 2023, when Altman was ousted by the board and then brought back five days later.
In the aftermath, Microsoft took a non-voting observer position on OpenAI’s board, only to relinquish that seat this year as both OpenAI and Microsoft came under more regulatory scrutiny.
What could make these negotiations even more challenging for OpenAI is that unfair compensation to the non-profit could expose OpenAI to legal challenges, according to Rose Chan Loui, founding executive director of the University of California Los Angeles's Lowell Milken Center for Philanthropy and Nonprofits.
State attorney generals, particularly in Delaware where the non-profit is registered, could file suit against parties that violate that legal requirement.
"One question the investment bankers have to ask is how realistic people are about the valuation…even the negotiation," she said. "I'm wondering who's going to speak for the nonprofit because the other side might have incentive to devalue it."
On top of that, Chan Loui said, fair market value would typically include a premium to the non-profit for giving up future participation and majority control.
Microsoft, legal experts said, should be prepared for significant ongoing outlays to transition away from a non-profit model, as more money will be needed for the valuation work, legal compliance and operational integration.
OpenAI has said it would seek to become a public benefit corporation (PBC), which is required to balance shareholder interests with broader societal benefits.
"Microsoft’s financial exposure is not limited to its initial investment," Alon-Beck said.
Alexis Keenan is a legal reporter for Yahoo Finance. Follow Alexis on X @alexiskweed.
