See Part 2 of our series, Valuing Equity Interests in Complex Capital Structures: Case Studies.

Valuing equity interests for portfolio companies, such as venture capital-backed and private equity-backed companies, usually requires more complex methodologies than valuing based on pro rata shares of the equity value. This is because many companies are financed by a combination of different classes of equity, each of which provides its holders with unique rights and privileges, as well as protective provisions. Valuing equity interest in complex capital structures is required for a variety of purposes, including financial reporting, tax purposes, transaction advisory analytics, optimal deal structuring, and model validation.

Financial Accounting Standards Board Accounting Standards Codification Topic 820 (FASB ASC 820), Fair Value Measurement, establishes the framework for measuring fair value and requires disclosure about fair value measurements. FASB ASC 820 is a broad principle-based standard that applies to all entities, transactions, and instruments that require or permit fair value measurements. Internal Revenue Code (IRC) 409(a) generally requires privately held companies with securities not readily tradable on a market to measure the fair value of the underlying securities for the purpose of “non-qualified deferred compensation.”

Today’s valuation practitioners use numerous methods for valuing equity interests in complex capital structures, each with their advantages and disadvantages. The selection of valuation methods depends on the type of business of the subject company, complexity of the capital structure, subject company’s strategic exit plan, and transaction-specific conditions. This discussion outlines the four most widely accepted valuation methods and includes a case study for each method to address the recent developments of these valuation areas covered in the AICPA Valuation Guide^[1] (the “Guide”), titled “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies.” Herein, we present a thorough content summary of the Guide; for more details on the valuation requirements and applicability of each method, please refer to the Guide.

The four most widely accepted valuation methods used for fair value measurement of multi-share capital structures are the following:

• The Probability-Weighted Expected Return Method (PWERM)
• The Option Pricing Method (OPM)
• The Current Value Method (CVM)
• The Hybrid Method

A summary of each method and a description of the fundamental framework and important notes to consider are presented below for each of these methods.

Probability-Weighted Expected Return Method

The Probability-Weighted Expected Return Method (PWERM) assumes various types of future exit outcomes (e.g., initial public offering (IPO), merger and acquisition (M&A)), allocates the present values of the probability-weighted future equity values to each share class under every scenario, and discounts them at a risk-adjusted rate.

The application of the PWERM generally involves the following steps:

• Determining the number and nature of possible future exit outcomes
• Estimating the future equity value of the subject company under each possible outcome
• Allocating the future equity value to each share class
• Estimating the expected future probability-weighted cash flows to each share class
• Discounting the allocated future value of each share class from present value using a risk-adjusted discount rate
• Concluding on value of the subject interest

When applying PWERM in valuing the subject interest in complex capital structures, special consideration should be given to the risk-adjusted discount rate used to determine the present value of the future equity value. If there is an applicable recent financing round, the selected discount rate should be solved such that the total present value of the probability-weighted future equity values is equal to the equity value implied by the most recent financing round. The valuation practitioners should also consider whether the discount rate for each share class needs to be adjusted based on the relative risk of each class. Generally, the weighted average discount rate across all share classes should equal the cost of the equity of the subject company. In some cases, the scenarios considered in the PWERM analysis may incorporate a different level of company-specific risk, depending on the aggressiveness of the company’s projections. Thus, additional risk premiums need to be applied to applicable scenarios, and the present value of each share class needs to be estimated based on different a discount rate under every scenario. Overall, when applying PWERM analyses, selection of the probabilities of each future outcome, nature and aggressiveness of the projected outcomes, and selected discount rates should all be aligned and viewed in totality rather than independently.

The main advantages of the PWERM are as follows:

• It is a forward-looking method, since it contemplates a specific liquidity event in a short timeframe and incorporates expectations about future outcomes into the estimated present value
• If the PWERM analysis uses reasonable assumptions and relies on calibration to the most recent financing transactions, the estimated equity values are not too sensitive to the changes in probability of future outcomes, except when one outcome has an extremely high probability
• It is an appropriate method to use when the expected exit timing is short (usually less than 12 months) and the possible future outcomes are easy to predict

In contrast, the main limitations of the PWERM are the following:

• The PWERM requires detailed documentation and appropriate qualitative assessment of future possible outcomes (i.e. certain pre-IPO exit values and concrete timing after consideration of a potential S-1 filing)
• Justifying the appropriate discount rate to use is challenging due to its reliance on the riskiness based on how aggressive or conservative the company’s projections are
• It is also a challenge to capture cross-over financing rounds and the impact on the overall post-transaction risk profile of the company. As a result, more assumptions need to be introduced by a cross-over round consideration, which will impact the overall risk profile and business prospects of the company
• The PWERM is not appropriate to use when valuing option-like payoffs, which is a fundamental for incentive awards
• The PWERM is also not appropriate to use when measuring premiums associated with controlling ownership characteristics

Option Pricing Method

The Option Pricing Method (OPM) uses an option-like payoff structure and relies on the Black-Scholes framework and the Theory of Rational Option Pricing^[2] by Robert Merton, which infers that equity can be treated as a call option on the assets of the company, with its strike price equal to the price of the company’s debt outstanding. This theory can be extended to valuing multi-class capital structures, where each security class can be treated as a call option on the equity or enterprise value of the company with a strike price equal to the appropriate participating threshold for that individual class. The OPM is simply an allocation method that estimates the current equity value to each security class based on its rights and privileges. The current equity value is treated as a combination of call options valued using the Black-Scholes model to reflect the incremental participation claims of the various security classes based on its level of seniority of claim to the company’s liquidation distribution.

One of the key inputs to the Black-Scholes framework and OPM analysis is the asset price, which is the equity value of the company, adjusted equity value (i.e. a portion of the capital structure outstanding; for instance, in some cases the most senior preferred stock is excluded from OPM analysis if it can be valued similar to a straight debt instrument), or enterprise value. In an OPM framework, the current equity value may be calibrated to the most recent financing round with appropriate assumptions for the expected time to a liquidity event, volatility, and risk-free rates such that the value for the most recent financing round equals the purchase price paid. However, since the OPM framework considers the full value of downside protection of the senior security classes using a lognormal distribution, the equity value used in an OPM framework will typically be lower than the post-money transaction value, which assumes all security classes participate on a pro rata basis. In addition, the OPM framework does not consider the dilution impact of any subsequent financing rounds or the dilution impact of any future issuance of options and warrants.

The main advantages of the OPM are as follows:

• The framework recognizes the option-like payoff structure of various security classes, which is the key driver for the incentive awards
• It reflects the rights and privileges of the various security classes based on the appropriate seniority and liquidation rights
• It is a forward-looking method that takes into consideration any appreciation or depreciation of value in terms of the overall equity value of the company as it progresses to a future liquidity event
• The OPM framework is easy to implement and is a good approximation in certain non-vanilla option payoffs, such as performance-based options with linear or nonlinear payoffs

In contrast, the main limitations of the OPM are the following:

• The OPM framework is sensitive to key assumptions, such as volatility or the expected time to a liquidity event
• It is challenging to reflect appropriately the premium position of controlling shareholders and their impact into the strategic exit plan of the company as well as the monetization and realization of their returns based on their investment style, portfolio structure and market conditions
• It does not capture any round-down protective provisions that are common in financing rounds based on the issuance of new classes of equity
• It is only a good approximation when considering non-vanilla market-vesting conditions (i.e., linear interpolation between certain Multiple of Invested Capital (MOIC) or Internal Rate of Return (IRR) hurdles). However, the most appropriate valuation framework in these instances is Monte Carlo simulation, which is a more dynamic and path-dependent valuation framework where the future total assets or equity value of the company is simulated for a large number of trials

Current Value Method

The Current Value Method (CVM) is simply a waterfall analysis based on the equity value and outstanding capital structure of the company as of the current date. The CVM framework is applicable mainly in two cases, which are as follows: (i) there is an immediate liquidity event, such as the acquisition or dissolution of the company, and the expectations about the future of the company as a going concern is irrelevant; and (ii) the subject interest class has seniority over the other security classes of the company, and the holders of the subject interest class have control over the exit timing.

The main advantages of the CVM are as follows:

• The CVM framework is easy to implement and usually not computationally intensive
• It considers the rights and privileges of various security classes in the capital structure as of any given date
• There is no consideration of qualitative assumptions related to potential future exit timing strategies or multiple scenarios to determine the forward-looking path of the company

In contrast, the main limitations of the CVM are the following:

• The framework is highly sensitive to changes in the waterfall assumptions
• It is not forward looking and does not reflect any material business achievements or fundamental company milestones that might affect the overall value of the company
• It does not capture option-like payoffs, and thus, underestimates the values of equity incentive awards, such as options, warrants, or profit interests

Hybrid Method

The Hybrid Method is a combination of the PWERM and OPM, based on the consideration of multiple scenarios and allocation of value for each scenario using the OPM framework. The hybrid method is appropriate for use in the following circumstances:

• Multiple potential exit scenarios in the short-term horizon with different probabilities
• Consideration of an anticipated financing or crossover round with a certain likelihood
• Consideration of future outcomes based on the successful satisfaction of certain business contractual requirements (e.g., Food and Drug Administration (FDA) approval of a certain drug or product)
• Consideration of capitalization structure changes based on the achievement of certain milestones (i.e., targeted acquisitions)

The main advantages of the hybrid method are the following:

• It is a forward-looking method that considers specific types of liquidity events in the assumed holding period and incorporates expectations about future economic events
• The hybrid method recognizes the option-like payoffs of various security classes, which is a key driver of the value for the incentive awards
• It appropriately reflects the rights and privileges of various security classes based on the level of seniority and the liquidation preferences of individual classes
• It reflects a wider range of potential future economic outcomes and represents a better solution when management considers several alternative management strategies and wants to know the effect on the fair value consideration under each strategy

In contrast, the main limitations of the hybrid method are as follows:

• The hybrid method requires a larger set of qualitative assumptions (i.e., specific exit timing and respective probability for each scenario)
• Applying the hybrid method may become over complicated by including additional scenarios in the analysis, with significant impact on the capitalization structure of each potential future outcome and the overall valuation framework

View the related case studies for our analysis. 

Also contributing to this article: 

Lucy Cheng
Associate, Valuation Advisory
+1.646.810.4402
lcheng@stout.com

1. Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies - Accounting and Valuation Guide, American Institute of CPAs.
2. Robert Merton, "The Theory of Rational Option Pricing," The Bell Journal of Economics and Management Science, March 1973.