Valuation of Complex Capital Structure
By Gustavo Perez, ASA, IA; Principal, National Leader, Valuation Services
The valuation of different layers of ownership securities in companies with complex capital structures has been gaining popularity among those looking to raise capital, as well as with investors willing to provide such capital in exchange for securities that are senior to common stock while still providing greater returns than debt. In addition, many companies see stock-based compensation grants, commonly referred as “cheap stock,” as a way to align their goals with the goals of their employees. As these securities continue gaining popularity among investors, employees and companies, the Internal Revenue service (“IRS”) and Security and Exchange Commission (“SEC”) have increased the scrutiny, and frequently targeted valuations, of these securities to insure compliance with financial reporting (ASC 718) and Internal Revenue Code Section 409A (IRC 409A).
For financial specialists who provide valuation services, the valuation and allocation of the total value of a company among its different classes of securities can be a difficult and daunting task. Fortunately, the American Institute of Certificate Public Accountants (“AICPA”) has recognized the need for guidance in this area. In 2004, the AICPA issued a practice aid to assist in the valuation and disclosure related to the issuance of privately held company equity securities issued as compensation. In 2013, the AICPA replaced the 2004 edition when it published Valuation of Privately-Held-Company Equity Securities Issued as Compensation, (the Practice Aid). This publication, often referred to as the “Cheap Stock Guide,” presented various methodologies for allocating the enterprise value (EV) of an entity across its different classes of securities.
Overview of Allocation of Value Techniques for Complex Capital Structures
In order for us to allocate the EV of a company among its different classes of securities, we need to understand the total EV of a company. This includes all classes of securities such as debt, preferred and common stock. Common shareholders are considered to have the residual claim on the value of the company after senior securities, such as debt and preferred equity, have received their returns. The AICPA Practice Aid introduces several methodologies to allocate EV among the different classes of securities, including the Current Value Method (CVM), Option Pricing Method (OPM), and Probability Weighted Expected Returns Method (PWERM).
The Current Value Method, also referred to as the “Waterfall Method,” is the most straightforward and simplest method. It is based on allocating the EV across the various classes of securities, in conformance with liquidation preferences and conversion values. The residual value is then allocated to common shareholders. The CVM of allocation is based on initially estimating EV on a controlling basis and assuming an immediate sale of the enterprise. This method calls for allocating that value to the various series of preferred stock based on liquidation preferences or conversion values, whichever would be greater. Although fairly easy to implement, this method’s usefulness is limited to situations in which a liquidity event (e.g. acquisition, IPO, or dissolution) is imminent or expectations about the business continuing as a going concern is not applicable.
The Practice Aid includes other methodologies to address the allocation of EV under different circumstances. These methods assume the value of each security is based on the timing and uncertainty of future economic benefits. For instance, Option Pricing Method is considered most appropriate when specific liquidity events are difficult to forecast. It considers each class of stock a call option with a claim on the EV of the company, and allocates EV based on a breakpoint or on payoff scenarios, in accordance with liquidity preferences, conversion features and other attributes. This method is fairly complex, particularly when multiple classes of convertible preferred shares, stock options and warrants are present.
The Probability Weighted Expected Returns Method is based on assigning probabilities to possible future scenarios such as an IPO, merger, acquisition, liquidation or continued operations. The future values are then allocated among the different classes of securities according to its rights and the probabilities assigned to each future event. The allocated EVs are then discounted to present value using a risk-adjusted discount rate. This method incorporates expectations about forward looking events. It can be complex to implement and is sensitive to subjective assumptions.
An additional technique, the Backsolve Method, is a form of the market approach that relies on previous transactions involving other classes of securities (e.g. preferred shares) to estimate the value of one class of security (e.g. common shares). Using the pricing of recent transactions as a known value for a specific security, the Backsolve Method can also be used in conjunction with the OPM and PWERM to value multiple classes of securities. Further, this method involves an iterative process inferring an EV for the total company equal the price of the recent transaction.
The valuation of complex capital structure requires an understanding of sophisticated financial theory together with in-depth knowledge of the AICPA Practice Aid. Obtaining a sound, auditable and defensible appraisal is critical to protect company employees from potential tax and penalty assessments by the IRS, and providing credible support to withstand the scrutiny of SEC inquiries.
At Cherry Bekaert, our analysis is prepared in accordance with ASC 718, IRC 409A and the AICPA Practice Aid.