[IMGCAP(1)]Last August, the American Institute of CPAs released an exposure draft of its updated guidance on the Valuation of Privately Held Company Equity Securities Issued as Compensation.
This working draft serves to codify the accumulated best practices that have evolved over the eight years since the original practice aid was issued, in part confirming much of what is already being applied in current valuations. The official updated guidance is expected to be released by June.
The original work was groundbreaking in the sense that it defined methodologies with a theoretical base to measure the relative equity value in a capital structure with distinct equity securities, defined by unique economic rights and preferences. Prior valuation work and standards employed conventions that were loosely based on observation and offered expediency. For example, they might use common stock priced at 10 percent of the latest round of preferred or, more commonly, apply the latest preferred price to a fully-diluted capital structure to imply the “post-money” value of the equity.
The 2004 practice aid defined three methodologies able to value the unique equity securities by giving consideration to their economic terms, including seniority, liquidation preferences and conversion rights. The current value method, probability-weighted expected return method (PWERM) and the option-pricing method (OPM) were introduced and now serve as the foundation of the valuation process. The required inputs vary by selected method and objectivity, and may rely on assumptions that are either difficult to observe or to verify. Still, each approach applies financial-economic theory in a way that brings rigor and scrutiny to the analysis of a complex equity structure in a way that is auditable and transferrable across valuation specialists.
Eight years of practice and application to a tremendously wide variety of equity structures have advanced the thinking on valuation and resulted in a number of ideas widely in use today. These include significant thoughts about incorporating a recent financing round (a market approach referred to as a “backsolve”), and the use of hybrid approaches that combine a PWERM and OPM to better incorporate potential forms and timings for future liquidity events. More subtle concepts are also advanced in the areas of discounts for lack of marketability, relevered volatility, inclusion of debt in the allocation process, and the valuation of profits interests, to name a few. The updated practice aid addresses many of these specialty topics in a manner that emphasizes application.
Fortunately, many of these applications are extensions of or are derived from the core allocation methodologies defined by the original practice aid. Some are more conceptual in nature, such as the backsolve market approach, while others are more technically oriented, such as the introduction of the differential put used to estimate a marketability discount applicable to the desired equity security.
In our experience, the OPM has come to be the dominant method for equity allocation. It is the most common methodology employed and most often preferred in audit review. The reason stems from the limited applicability of the other approaches. The current value method explicitly ignores time, limiting its application to situations in which a liquidity event is imminent or known. Still it emphasizes the waterfall concept that is also central to the PWERM and OPM.
However, these methods implicitly consider the separation of a liquidity event from the present, meaning the element of time is captured. The PWERM is most effective when a good deal of information and expectation is in place with respect to a future liquidity event, e.g., pricing, timing, probability and so forth. A PWERM generally applies to corporate entities that do not require further financing, and indeed are closing in on an exit.
Outside of these specific conditions in a corporation’s operating and financing timeline, the OPM is the most broadly applicable. In some sense, the less that is known about the future, the more applicable this method becomes, since its underlying valuation process is based on the Black-Scholes option pricing formulation, which presumes a continuous distribution of possible future equity values. Where this presumption breaks down—for example, some specific consideration (probability) is warranted for a targeted sale or IPO—the OPM may be supplemented by a PWERM and referred to as a hybrid method.
It is significant to note that as a volatility/time-based model, the OPM has the luxury of avoiding the estimation of a discount rate applicable to future cash flows, unlike the PWERM. In addition, since the individual equity securities generally are not income-producing, both the OPM and PWERM allow valuation professionals to look directly into the future to the liquidity event distribution to assess the character and fair value of the structured equity as of a specific valuation date.
The OPM’s framework is acceptable for much of a private company’s timeline, i.e., the initial capitalization to liquidity distribution, and is well-suited to capturing the payoff function of common stock and other junior or subordinate equity claims that express time value. These junior securities benefit from the upside in total equity and have zero liability, exactly analogous to a call option. Thus, the mechanics and underlying principles of option-pricing theory are useful in a preferred equity valuation context and are convenient for audit support.
The updated practice aid confirms the application of the OPM and PWERM equity allocation methods as standard practice and illustrates their extended use and the evolving consideration of practical issues that commonly surface in private company equity analysis. This updated aid memorializes the collective efforts and thought over the last eight years.
Rob Barnett is senior vice president of Valuation Research Corporation. He specializes in the valuation of complex securities including derivatives, convertible securities, structured products and credit-linked investments, and various forms of equity and debt related to transactions, private placements, and public offerings. Barnett also has significant experience providing business enterprise and intangible asset valuations for financial reporting purposes. In addition, he has completed numerous valuations for tax purposes, including Section 409A and transfer pricing. Prior to joining Valuation Research, he held positions with Ernst & Young, Kroll Associates, Houlihan Lokey Howard & Zukin, and KPMG. Barnett holds the designations of chartered financial analyst and financial risk manager.