[IMGCAP(1)]With the formal release of the 2013 AICPA Guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, there are two valuation concepts that are new to the updated guide, but are already in fairly wide use.
Each method is an extension of fundamental allocation concepts and methods, but is designed to better address specific circumstances or fact-patterns leading to a more comprehensive valuation estimate. By their nature, they will only be relevant in certain situations, and would not be considered in a more universal sense. The two concepts are the use of a market approach known as the backsolve method and the use of an income approach known as the hybrid method.
The backsolve method derives from a timely transaction in a private company’s equity. The transaction typically is a new financing round that has either recently closed or will close in the very near future. Meaningful financings are critical in the progression of a private company. These financing rounds are strongly negotiated, reflect expectations about the company at a moment in time, and give full consideration to the capital structure.
The strength of a financing round as an indicator of value is enhanced by the sophistication level of the investors and the breadth of participation, in particular the mix of existing and new investors. A qualitative understanding of the financing round assists with assessing the degree to which the current price impounds the economics of the capital structure and the company’s total equity value, versus requiring additional adjustment.
For private companies that inherently lack active markets in their equity securities, that may not have reached positive EBITDA, that may still be pre-revenue, or that may have discounted cash flow analyses where terminal value is close to or in excess of 100 percent of the estimated total equity value, the backsolve can be one of the strongest indicators of value.
The term backsolve comes from applying the equity allocation in reverse. Rather than developing a company’s total equity value and then working through an equity allocation method to estimate the individual equity security values, the total equity is implied by the current financing round.
That is, the total equity value that works its way through the capital structure in an allocation process, such as an option-pricing method (OPM), is the total equity value that prices the current preferred issuance. This resulting (“solved-for”) total equity value is the “post-money” valuation of the company, albeit not as the term is traditionally understood. In actuality, the only truly observable value indicator is the financing round (e.g. the Series C); everything else is implied by the current financing, the economic rights and the allocation inputs such as volatility and term for the option pricing-method.
Post-money valuation in its conventional form is taken to mean a total equity value that considers all outstanding equity shares, including those dilutive securities that are in-the-money (ignoring option proceeds), at the price of the recent round.
For example, if a new Series C round is priced at $5.00 per share, then the post-money valuation would be $50 million if the total number of shares in the capital structure is 10 million. This post-money convention is reasonable in the event that the total equity value is sufficient to view the securities on a fully-converted basis giving little or no value to the preferred liquidation preferences. However, companies essentially functioning as fully converted capital structures are not the ones typically raising funds and negotiating preferred security terms. The companies raising capital and negotiating terms are generally the ones where preferences still matter. As such, a backsolve will always result in an implied (“post-money”) value that is often meaningfully less than the conventional post-money calculation.
Venture capital-backed and private equity-backed investments seek future liquidity events; thus, the allocation methods consider the fair value of the different equity classes based on the future payoffs at the time of the liquidity event. When expectations about the timing and form of liquidation become relatively more understood, the use of a hybrid method can be particularly useful.
Where an OPM works well for companies that have three to five years to liquidity and no clear exit value, a hybrid approach that also incorporates a probability-weighted expected return method (PWERM) can prove especially useful as future options regarding liquidity and valuation become clearer to the company.
Thus, a hybrid approach is one that combines two or more allocation methods to better capture an increasingly discontinuous outlook. For example, a near-term IPO may have recently become a very significant possibility for a company, but still has some uncertainty about timing and valuation. A PWERM may be used to model equity payoffs under assumptions regarding the IPO, and an OPM with a longer outlook could support the equity allocation in the event the IPO is delayed.
Note that in applying a hybrid method we would typically expect to work with different current equity values, but the probability-weighted current equity values should reconcile to the overall equity value for the company. That check serves as a useful governor on the assumptions about future exits and values and the likelihood (i.e., weights) ascribed to those outcomes. Thus, the hybrid method is not intended to tell a different story regarding the current equity value, but is intended to better capture the possible pay-offs to the individual equity securities.
In summary, when working with private company equity security valuations, be very cognizant of the company’s financing history, especially recent (less than six months) financings. And also have sufficient understanding about the company’s current and evolving outlook with respect to its liquidity options.
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.
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