Key Valuation Factors for ASC 718 and 409(a) and Financing Calibration
Key Valuation Factors for ASC 718 and 409(a) and Financing Calibration
There are various factors that we analyze and consider when determining the appropriate valuation framework for financial reporting in accordance with ASC 718 or 820 or for tax in accordance with IRC 409(a) guidelines. Those parameters revolve around company-specific information and broader market/industry characteristics.
Considerations When Determining Proper Valuation Framework
Company-Specific Information |
Broader Market and Industry Characteristics |
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Depending on the nature of available information, the risk profile, growth prospects, and overall business stage of the company as well as the engagement scope, we decide on the appropriate valuation technique in accordance with the valuation principles outlined in Chapters 5-9 of the 2019 AICPA Guide for the “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies” (2019 Guide), as well as the relevant guidelines of ASC 718 and 820.
In this article, we will discuss the key factors that valuation appraisers, audit teams, fund managers, and financial controllers should consider when relying on a recent financing deal that is considered an arm’s-length transaction.
Using Transaction Pricing Information for Accurate Equity Valuation
If transaction and respective pricing information is available, we can utilize the deal pricing, total capital raised, and specific pricing information for the security under consideration. This is to perform a backsolve approach by using a quantitative Black Scholes Option Pricing Model (BSOPM) or similar approach. That approach will allow us to derive an overall equity value (EV) for the company as well as specific fair value (FV) or fair market value (FMV) indications for the subject interest equity classes under consideration.
Depending on the complexity of the capital structure, economic rights, and privileges of the various equity classes issued and outstanding and the potential strategic exit paths contemplated, special consideration should be given to the underlying framework. This is to avoid any material mispricing problems due to inflated or understated values related to limitations of the implemented valuation technique.
Key Framework Considerations for Complex Capital Structures
Evaluating Valuation With Material Downside Protection Rights and Uncertain Dual Exit Paths (When No Specific Pricing Information or Exit Date Is Yet Determined)
In this case, the Hybrid Method should be used with the introduction of two or more scenarios that consider alternative exit path opportunities and different capital structure assumptions in each scenario. A fully diluted as converted scenario (FD) is typically introduced in those cases to account for limitations implied by the risk neutral framework that might lead to overvaluation of the more senior securities and yield a materially lower than the post-money valuation (PMV) implied equity value.
An adjustment of the number of scenarios to account for a potential dissolution scenario or alternative recapitalization scenarios could also be evaluated depending on the state of the business and anticipated future business events.
Additionally, careful consideration of the implied return metrics and pricing delta of senior preferred instruments relative to junior instruments and common stock instruments could provide significant insights about the appropriateness of the implemented assumptions and approach.
Adjusting Valuation Approaches When Specific Exit Information Becomes Available
When companies approach the potential exit date and there is specific deal information availability with a sufficient probabilistic assessment, the valuation framework should be adjusted to account for information that is known or knowable as of the valuation date. Typical examples are an S-1 filing before going public and the availability of specific investment bankers’ pricing datapoints.
In those cases, the introduction of a hybrid approach with a probability weighted expected return method (PWERM) is deemed necessary to account for specific exit value estimates based on a specified risky discount rate that reconciles the organic growth from the current fair value of equity with the appropriate step-up adjustment.
If there are various scenarios considered with different risk profiles and probability assessments, then the PWERM approach is adjusted accordingly to incorporate all those different finite modeling scenarios with the respective implications on the discount rate and probability assignment. Similar valuation adjustments are performed in recapitalization events or buyout transactions when deal pricing information is available and management can provide specific information about the various strategic events contemplated with a higher confidence level.
Robust and Material Secondary Transaction Pricing Information
If there is statistically significant and robust evidence in the secondary market (primarily from sophisticated institutional investors), that is not necessarily linked to the consummation of a potential financing round. It may refer to underlying equity classes different than the contemplated security issued in the last financing round. In these cases, valuation professionals should consider those as credible sources of pricing information from willing buyers and sellers.
Those pricing datapoints can be used to infer significant valuation conclusions about how market participants assess the value differential between the various securities as well as about the perceived riskiness of the investments and the assumed horizon until the potential monetization event.
More specifically, secondary pricing information could be leveraged within the utilized hybrid framework to infer market participant probabilities for dual events considered. When those inputs have been provided by management with a higher level of confidence, secondary pricing information could be used to infer specific investor assumptions about the holding period or the implied equity volatility of the company.
Incorporation of Stock-Based Compensation Adjustments
It’s important to capture investor expectations in the appropriate valuation method to avoid mispriced observations. Per the specific guidance of Q&A 14.27 of the 2019 Guide, since market participants typically assume it’s a company’s responsibility to pay for the equity-portion compensation attributable to employees, the valuation considerations of deal participants are net of the impact of stock-based compensation.
That said, to properly account for this treatment when calibrating the EV to a specific price estimate for an underlying class, valuation appraisers typically need to isolate the impact of the stock-based compensation and treat this as incremental non-dilutive.
A careful analysis of the vested portion of any historical awards and the deployment of a Current Value Method (CVM), which is essentially a current waterfall analysis assuming an imminent liquidity event, ensures that the sponsor or the primary economic units are not diluted by the optionality of equity awards in a way that is inconsistent with the deal pricing mechanisms.
Use of Risk-Adjusted Metrics
When a single BSOPM approach is appropriate due to the early stage of a company, perceived investment risk profile, or simplicity of the capital structure, careful consideration should be given to the appropriateness of the BSOPM assumptions. A close evaluation of the implied internal rate of return (IRR), or the conversion probability (N[d2]) of any preferred classes and the ratio of the present value of the downside protection relative to the as-converted feature could provide significant inputs about the robustness of the selected approach.
The BSOPM represents a static approach that assumes a specific point estimate for the assumed investment exit date, which deviates from the real-world strategies since investors strategically select the optimal exit frame based on various investment specific and market considerations. Considering that, this limitation to a static benchmark might yield unrealistic expectations relative to a more dynamic real options or multi-period Monte Carlo (MC) simulation approach.
In those cases, risk-adjusted metrics for the assumed investment horizon or the assumed equity volatility of the company/firm (i.e., higher investment term and higher volatility based on a return on equity beta calculation) might be used such that implied return characteristics of the primary economic classes are closer to real world target IRR and investor behavior expectations.
Size adjustments for the volatility and consideration of the stage of business growth as well as typical private equity returns per stage can help construct a more appropriate volatility build-up and minimize the likelihood of mispricing.
Alternatives to the Hybrid Approach and BSOPM
There are several alternatives to the BSOPM or Hybrid framework that could be considered when dealing with securities with significant downside protection rights (i.e., seniority, high liquidation preference multiple, high PIK yield, etc.) or other hybrid equity instruments.
In those cases, a bond + call approach, the zero coupon bond yield equivalent method (ZCBE), common + risky put, Hybrid with as Converted OPM, and others might be appropriate. A careful consideration of the limitations and underlying assumptions of each approach, the complexities of the capital structure, the assumed investment horizon, and the various pricing information available in the secondary market could help valuation professionals determine the optimal valuation framework.
SAFEs or Convertible Notes
The presence of SAFEs and convertible notes in primarily venture capital (VC) backed deals has become more relevant. They have been a great tool for VC contract design that ensures optimal allocation of cash flows and controlling rights between VCs and insiders in various economic states. Additionally, they have been documented by various large scale academic research efforts published in top international scientific journals.
As such, it is important for valuation professionals to properly assess the features of those instruments (i.e., discount factor, valuation cap, combination of both, etc.) and their valuation implications.
Depending on the actual economic characteristics and any other deal sweeteners that might have been given to the investors in connection with the contemplated instruments (i.e., warrants, target common stock ownership, etc.), a bond + call approach or a hybrid approach or a more complicated MC approach might be deemed necessary. This would be to account for the contractual economic features, the expectation about the potential conversion mechanisms, and the actual riskiness.
If the calibrated implied return metric is not consistent with general market participant expectations or the idiosyncratic risk is unjustified based on the rest of the financial information available, an adjustment to the hybrid method or similar approach to include a dissolution or low recovery approach that yields more realistic risk adjusted metric observations might be necessary.
Distressed Situations or Total Enterprise Value (TEV) Allocation
In cases of high leverage or high idiosyncratic risk where there are significant concerns about the ability of the company to continue as a going concern, careful consideration of controlling and downside protection rights is necessary. Additionally, the importance of the CVM framework becomes evident in appropriately allocating cash flows rights.
When there are different seniorities of debt, mezzanine debt, and/or subordinate preferred claims, a BSOPM application with a TEV and an asset volatility input might be considered as an alternative to an Income Approach or other similar approaches. That approach may deal with limitations in quantifying a high yield indication when utilizing risk adjusted inputs to avoid outliers or structural limitations of the OPM.
This framework can also be used where there are periodic cash flow payments attributable to debt instruments. These are cash interest payments that are modeled separately due to the differences in the payment windows and frequency of cash flows. The risk neutral implied yield attributable to the principal recovery can be used as the appropriate yield for the interim cash flow payment in the discounted cash flows analysis (DCF) post calibration.
Dynamic Market-Based Vesting Awards
It is standard practice for PE or VC backed companies/firms to issue a combination of time, performance, or market and performance-based vesting options or profit interests/incentive units to ensure alignment of interests between employees with investors.
Some of those market-based vesting awards are subject to step-up vesting thresholds with binary vesting treatment, but some of the more complicated ones are subject to linear interpolation between various IRR and/or multiple of invested capital (MOIC) thresholds.
In those cases, even though a closed form BSOPM approximation with finite modeling of the various interim vesting points as separate breakpoints will provide fair value indications that might have a minor standard error, it is more appropriate to rely on a more dynamic and robust MC simulation approach and capture the variability of vesting terms based on different exit values in a dynamic way.
MC simulation allows for a higher flexibility modeling treatment of the various economic terms in connection with the ending realized equity value. This is because it is open ended and user friendly for more computationally intensive valuation exercises (such as when specific subsequent financing round assumptions, convertible notes conversion, or modeling of other contemplated features or events is required).
Special attention should be given to minimizing the standard error of the MC simulation. This can be achieved by running a high number of simulation paths (> 100k). Doing so helps to ensure that the average metric of the simulated variable converges to the risk neutral expected value. Plus, the introduction of variance reduction techniques like the antithetic variates technique helps to minimize the standard error in the random number generation.
Backtesting
Even if the scope of the engagement specifies the reliance on pricing indications of a financing round or similar transaction such that a calibration through a BSOPM or similar approach is performed, it is still recommended to perform certain backtesting procedures. This is to verify the robustness and appropriateness of the yielded valuation indications.
Except for the return metrics outlined earlier, if a forecast is available, an implementation of a DCF analysis and a calibration to the implied valuation observation from the OPM would provide an answer with respect to whether the implied IRR for the given forecast and assumed growth prospects is reasonable.
Similarly, if no forecast is available, a market approach based on public comparable companies and a careful examination of the relative implied revenue or EBITDA or other multiple would also provide helpful additional datapoints for consideration. Sensitivities of the subject interest conclusions to the major valuation inputs are also recommended to better understand the pricing delta, rounding error implications of certain inputs, and yield conclusions with a higher confidence interval.
Scope and Framework Implications
The actual scope should be taken carefully into consideration to ensure compliance with applicable FV or FMV standards for financial reporting or tax compliance requirements, respectively.
The type of entity (Corporation vs. LLC) should be also taken into consideration in 409(a) engagements. This is important for determining the appropriate participation threshold or total FMV of equity for new contemplated awards. This determination should be based on the utilization of the proper valuation method (i.e., CVM in the case of profit interest units per the relevant guidance).
Consideration should also be given to the contractual FMV language in the agreement to understand Board guidelines and principles considered when granting new awards. Discounts for lack of marketability should be taken into consideration in accordance with the guidelines of Chapter 9 of the 2019 Guide. This ensures that appropriate and generally accepted conclusions are reached on a security basis. Factors to consider include structural differences in the risk profile of each instrument, the overall prospects of the company, and the assumed expected life of the asset.
Additionally, careful reading of the legal documents and modeling of special features (e.g., vesting acceleration upon a change of control, different treatment between an IPO vs. a sale) is important to ensure model robustness and compliance with applicable standards.
Third-Party Providers
Engaging a third-party valuation provider offers significant value in ensuring accurate and compliant valuations for ASC 718 and 409(a) engagements when relying on financing. These professionals bring a wealth of expertise and objectivity to the process, leveraging their deep understanding of valuation principles and methodologies.
By engaging a third-party valuation provider, companies benefit from an unbiased and thorough valuation process, ultimately leading to reliable and defensible valuation conclusions. This professional rigor supports informed decision making and enhances the credibility of financial reporting and tax compliance efforts.