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AICPA Issues Draft Guidance on Valuing Equity Interests Within Complex Capital Structures

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As we have previously written about in the third quarter edition of EisnerAmper’s Asset Management Intelligence, the AICPA’s Accounting and Valuation Guide: Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies (the “Guide”) describes possible methods for valuing equity interests within complex capital structures as well as provides a few examples.

Given the higher risks associated with investments by venture capital and growth private equity investors, they typically will demand downside protection and significant control over certain activities of the portfolio companies. This is typically accomplished through the issuance of different classes of equity, which have different rights, privileges and preferences. The rights provided to preferred stockholders fall into two categories – economic rights and non-economic rights. Economic rights include liquidation preferences, preferred dividends, participation rights, conversion rights and anti-dilution rights. Non-economic rights include voting, board, veto and management rights. These rights, privileges and preferences present an additional layer of complexity when allocating the value of the company to the various classes and specific ownership interest held by an investor. When estimating the value of an investment, it is necessary to determine how each class of equity participates in future distributions from a liquidity event and assess the impact on fair value for each of the classes.

Methodology

To value equity interests for companies with complex capital structures, four methods are generally utilized:

  1. Scenario-based methods,  including simplified scenario analysis, relative value analysis and full scenario analysis (“PWERM”);
  2. The Option Pricing Method (“OPM”);
  3. The Current Value Method (“CVM”); and
  4. The Hybrid Method, a combination of PWERM and OPM

Scenario-based methods consider the payoff to each class of equity based on a range of exit scenarios that then may be discounted back to the valuation date. A simplified scenario analysis is based on a post-money value of the company on a pro rata basis assuming all classes of equity are converted. This analysis can be suitable for situations where a company will either be successful or there will be limited value to distribute if unsuccessful. A relative value scenario analysis will consider the estimated pro rata share of the various equity interests and then calibrate a post-money value by applying probabilities to different outcomes and payoff values. This approach typically ignores discounting. A full scenario analysis (PWERM) estimates the value of the different classes of equity interests by analyzing potential future values, based on different outcomes (generally IPO, sale, dissolution).  The future values for each equity class are discounted back based on the required return for each class considering potential dilution from future financings. A PWERM approach is more typically used when a company is closer to an exit and different potential outcomes can be more readily ascertained.

The OPM model treats common stock and preferred stock as call options on the enterprise’s equity value, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, the common stock has value only if the funds available for distribution to shareholders exceed the value of the liquidation preferences at the time of a liquidity event (e.g., a merger, sale or IPO), assuming the company has funds available to make a liquidation preference meaningful and collectible by the shareholders. The common stock is modeled as a call option that gives its owner the right, but not the obligation, to buy the underlying equity value at a predetermined or exercise price. Thus, common stock is considered to be a call option with a claim on the equity at an exercise price equal to the remaining value immediately after the preferred stock is liquidated. The OPM begins with the current equity or enterprise value and estimates the future distribution of outcomes using a lognormal distribution around that current value. A key limitation of the OPM is the assumption of a lognormal distribution based on the subjective assumptions of volatility and term until exit. Additionally, holders of the preferred stock may have influence on the timing of an exit if the company is performing above or below initial expectations.

The CVM estimates the value of various classes of equity by allocating the current total equity value on a controlling basis, assuming an immediate sale of the company. While this methodology is easy to apply, for purposes of valuing a fund’s equity interest may be limited because it does not capture any of the option value for certain classes of equity. As such, this methodology is most appropriate when a liquidity event is imminent and when a fund’s position has sufficient elements of control over the timing of the exit.

The hybrid method, a combination of the PWERM and OPM, can be appropriate when there are expectations of a near-term liquidity event with a high probability; yet if the transaction is not consummated, the alternate path for the company is more uncertain, with a potential exit further out in the future. The PWERM component would apply the probabilities associated with a range of values for the near-term liquidity event to determine one component of the estimated value and the remaining probability would use an OPM over a more extended period. Conceptually, the hybrid method provides a good framework for valuation as it captures both expectations of different future values and potential optionality of certain equity classes; however, it can be complex to develop considering the numerous assumptions needed.

Conclusion

Each of the methods described have relative strengths and weaknesses and circumstances that are most conducive to use. It is important to understand the relationship of the different classes of equity, including gaining an understanding of the rights, both economic and non-economic, associated with each class.

These methods can be used to calibrate to the most recent round of financing and develop an appropriate valuation framework, which can be updated to reflect changes to the company and market conditions in subsequent periods. The use of calibration can also help to assess the impact of control and illiquidity issues relating to an investment.


Asset Management Intelligence – Q4 2018

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Michael Aronow CPA, Partner in EisnerAmper's Corporate Finance Group, has over 25 years of valuation experience which encompasses overseeing the auditing of fair value measurements for clients, including private equity and hedge funds.

Craig Ter Boss is a Principal in the Corporate Finance Group providing valuation services to public and private clients across a range of industries including consumer products, apparel, technology, business services and financial services.