Valuation Issues Related to Complex Capital Structure Equity Securities
With Internal Revenue Code Section 409A providing severe tax consequences to the option recipient of mispriced options, and Financial Accounting Standards ACS 718 requiring companies to expense the fair value of stock options, common stock valuations regarding early-stage, venture-backed companies have come under considerable scrutiny in recent years. These new rules impose a heavy burden on accounting departments to have dependable and up-to-date stock appraisals based upon acceptable methodologies.
Early-stage and venture-backed companies granting options are often capitalized with several classes of equity securities, each having unique economic and control rights. While, founders and employees (through stock options) generally hold Common Stock, investors typically seek disproportionately higher returns in the form of Preferred Stock, which may provide numerous rights over and above that of Common Stock. Some rounds of financing incorporate caps, accrued dividends, performance warrants and other valuation complexities. The presence of several classes of equity presents an additional layer of complexity, particularly related to value allocation. It is important to understand these intricate financial structures and their effect on value, since the value of a Common equity interest in such a structure is directly impacted by the features of other senior securities across various ranges of enterprise value.
Valuation Methodologies for Complex Capital Structures
In 2004, the AICPA issued its practice aid, “Valuation of Privately-Held-Company Equity Securities Issued as Compensation.” This publication introduced several methodologies for allocating enterprise value across multiple classes of securities, which have become the generally-accepted approaches for tax and financial reporting purposes. The three primary allocation methodologies include the Option Pricing Method (OPM), the Probability Weighted Expected Returns Method (PWERM) and the Current Value Method. The OPM and Current Value Method involve a two step process, consisting of (i) determining the value of the enterprise, and (ii) allocating enterprise value to each class of equity, while the PWERM accomplishes valuation and allocation in one step. Other methods can be utilized, but these methods have been most common in current practice. Each allocation method differs in its complexity, theoretical foundation, and appropriateness given the facts and circumstances of each case. The appraiser must use judgment to determine the appropriate methodology.
Option-Pricing Method (OPM)
Under the option-pricing method, each class of stock is modeled as a call option with a claim on the enterprise value of the Company. The options’ exercise prices are based on comparisons with the total enterprise value. Both the common stock and the preferred stock classes have, at the time of a liquidity event, “payoff diagrams” that are similar to the payoff diagrams of regular call options. The characteristics (such as liquidity preferences, conversion features, etc.) of each class of stock determine the class’s claim on the aggregate equity value. The OPM utilizes Black Scholes or binomial models to calculate value. This methodology is useful for valuing securities when there is a high degree of uncertainty regarding potential future outcomes. The OPM is an attractive methodology in that it considered the differences among multiple equity classes on a forward-looking basis, while not requiring as many assumptions as other models (such as the PWERM). The OPM is however, sensitive to the underlying assumptions of the Black Scholes or binomial models employed, particularly with respect to firm volatility.
Probability-Weighted Expected Return Method (PWERM)
Under the (PWERM) the value of common stock is estimated based upon an analysis of future values for the enterprise assuming various scenarios. The PWERM is rooted in decision-tree analysis and models potential future expected outcomes. The company’s enterprise value is estimated at the date of various assumed potential future outcomes (e.g. IPO, strategic sale, continued operations, liquidation). Each enterprise value is allocated among the different classes of equity based on the rights and characteristics of each equity. The resultant share value is based upon the probability-weighted present value of expected future investment returns. A primary advantage of the PWERM is its intuitive nature, making it easy to understand and follow conceptually. However, it relies on numerous assumptions regarding future outcomes and complex probability modeling, making the PWERM a complex undertaking in many cases.
Current Value Method
The Current Value Method of allocation is based on the enterprise value derived (via application of traditional valuation approaches) as of the valuation date, which is allocated to the various equity classes based on their liquidation preferences or their conversion values, whichever would be greater. Although this methodology is relatively clear and straightforward, it lacks the forward-looking perspective necessary to appropriately value many early-stage securities. In general, this allocation method is limited to situations in which (i) liquidation of the enterprise is eminent and (ii) expectations about the future going concern value of the enterprise are impractical.
Which Method is Appropriate?
Even in relatively simple situations, judgment related to the appropriate method and assumptions must be exercised based on various company-specific factors. Valuation models must be adapted to the specific facts and circumstances of the company and the securities being valued. Given the potentially burdensome implications of IRS and FASB standards, it is important to engage an appraiser with experience in approaching complex valuation issues. The analysts at Hempstead & Co. have this experience and proficiency, and are prepared to talk with you about any such valuation issues related to equity securities in complex capital structures.
