Valuation Issues in Complex Capital Structures

Many private equity (PE)-backed companies have multiple classes of equity; each class provides the holders with certain rights and preferences. Typical equity classes are preferred stock and common stock. Due to successive financing rounds, preferred stock often comprises multiple series or classes, with each class having unique rights and privileges; together, these classes form a complex capital structure. In certain instances, you’ll need to correctly allocate value to each of the equity classes to comply with tax and financial reporting requirements. Appropriately allocating value to each equity class is especially important when you’re issuing equity-based compensation to employees, recording investment values on financial statements, or considering a new financing round. While many companies with complex capital structures use a waterfall approach that is based on a current value, doing so often results in values that do not anticipate future outcomes, especially when the company does not face an imminent sale.

This article will walk you through common situations where an equity allocation is appropriate and will provide you with a basic understanding of the methods used to allocate value to the various equity classes within a complex capital structure.

When an Equity Valuation is Needed

1. Equity Compensation

Equity compensation is a powerful tool that helps align the interests of employees and the company and fosters employees’ commitment to the company. Employees can receive equity in the form of stock, stock options, phantom stock, incentive units, or appreciation rights, to name a few. Regardless of the equity instrument issued, its value must be determined appropriately in order to meet certain tax and accounting requirements. Not only are companies legally required to recognize the correct value, but individual employees can also face major tax issues if the valuation is not accurate or supportable. For tax purposes, you must make sure your company is in compliance with Internal Revenue Code (IRC) Section 409A (409A), and for accounting purposes, you need to adhere to Accounting Standards Codification (ASC) Topic 718, Compensation – Stock Compensation. Below is a brief outline of each.

• IRC Section 409A – This section of the tax code regulates nonqualified deferred compensation plans, which are, essentially, arrangements where employees receive compensation in a later tax year than the year in which they earned it. From a valuation perspective, the equity that is issued to employees as incentive compensation could fall within the scope of Section 409A. When private companies want to issue stock options, for example, as a form of incentive compensation, a valuation is required to ensure the exercise price of the stock option is equal to or greater than the fair market value (FMV) of the underlying stock. If that is not the case, the company could face severe tax penalties. Simply put, the IRS does not want companies making up or randomly estimating the value of the stock. If your privately held company is planning on issuing equity as compensation, you may want to consider a 409A valuation at the following times:
  • Before making a grant.
  • After a financing round.
  • After twelve months have passed (or sooner) since the most recent 409A valuation.
  • When a material event may have affected the company’s value.
• ASC Topic 718 – When companies are required to maintain GAAP-compliant financials, they may need to comply with ASC Topic 718 if they are issuing equity as compensation to employees. The standard outlined by ASC Topic 718 provides guidance on how to account for noncash or share-based payments on the company’s financial statements. In many instances, valuations are required in order to determine the value of the award issued as compensation as of the grant date and establish the liability on the income statement. For private companies, a valuation will be required to determine the value of the equity instrument that has been awarded since no public market exists for the stock, stock option, or other equity instrument. Even public companies may need a valuation in certain instances, depending on the features of the equity instrument that has been awarded.

2. Capital Raises or Sale of the Company

When you’re raising capital or selling your company, a valuation can be the essential component to help you determine the price, terms, and overall ownership interest for sale. In some instances, when you sell your company to a PE firm, you might receive a portion of the purchase price as rollover equity in the new company. That new company will likely have a complex capital structure. An independent valuation that allocates value to each equity class can help confirm the value you will receive, or, if the independent valuation differs from the expected value, it can help you with negotiations. Similarly, if you are raising capital through private equity, a valuation and equity allocation can assist you in determining the price and the ownership interest being sold. In addition, the valuation exercise can serve as a tool to assist you in negotiating the rights and features of the preferred investment.

3. Private Equity Investments

When PE firms make investments in companies, whether minority investments or outright acquisitions, the resulting equity structure commonly comprises preferred stock, common stock, and, in many instances, incentive units for key employees. With a complex capital structure and many years until a liquidity event, PE firms would benefit from an independent valuation of the position they hold in each portfolio company. The independent valuation would provide transparency in reporting to the limited partners of each fund and would ensure compliance with the auditing standards required by their independent audit firm.

4. Classifying Warrants

As an incentive to attract investors, whether in debt or equity financing, it is not uncommon for companies to issue warrants. Those warrants often include special features, such as limitations on exercise periods, anti-dilution provisions, or cash redemption. Depending on those features, the instrument could be classified as equity or a liability on the company’s balance sheet. The valuation often requires a complex model to address each of the potential future outcomes or scenarios.

Valuation Methods for Complex Capital Structures

As we have been discussing above, companies with complex capital structures, or even securities with complex features, are best described as, well, complex. While the initial phase of valuing a company with a complex capital structure is similar to any other company valuation, how that total value is allocated to the various equity classes is more involved. If a sale of your company is not imminent, a simple waterfall approach of subtracting the preferred liquidation preference from the total equity value (current value method) will not accurately value the junior securities, such as common stock. In that case, it may be several years before your company is sold, giving the common stock several years to benefit from potential upside in the company’s performance. In fact, the AICPA guidance, Valuation of Privately Held Company Equity Securities Issued as Compensation (the “Guide”), specifically addresses this issue and contends that the current value method (CVM) is most appropriate when a sale or dissolution of a company is imminent or when a company has not made any material progress in its business plan, meaning no material value has been created.

Accordingly, while the AICPA has acknowledged that no single method is superior to another, there are several methods that have merit and might even appear to be superior in theory – but in practice, it’s complicated. Below, we describe commonly used, widely accepted valuation methods.

• The Probability-Weighted Expected Return Method (PWERM), as the name would imply, is based on an analysis of future scenarios, such as an initial public offering (IPO), acquisition, or dissolution. This method estimates the value of the business under each scenario and then determines the value attributable to each equity class. The present value of each equity class is determined based on the expected date of the future event and the valuation date. Probabilities are then assigned to each scenario, often based on the management’s input and actual circumstances occurring at the time of the valuation exercise. The resulting value for each equity class is the sum of the probability-weighted expected returns.
  
  The advantages of using the PWERM is that it incorporates the rights and features of each equity class and the ability to account for future events. The main limitation of the PWERM is that it requires estimates of potential future outcomes, their expected dates, and the probabilities for each of those scenarios. Because the PWERM relies on multiple assumptions, it is best used when the path to liquidity is short.
  
  
• The Option Pricing Model (OPM) treats each equity class as a call option on the total equity value of the company. The exercise price for each call option is derived from the liquidation preferences of the preferred equity classes. Common stock only has value if proceeds from the liquidity event exceed the value of the preferred stock’s liquidation preferences. Under this method, common stock is modeled as a call option with a claim on equity. The exercise price is equal to the remaining value immediately after the preferred stock is liquidated. The OPM can use the implied value from a recent financing round or an equity value estimated using conventional valuation approaches.
  
  The OPM considers the various terms that govern the distribution to each equity class, including dividends, conversion, and participation rights. Under this framework, the Black-Scholes formula is commonly used to value the call options. However, some OPM valuations may require other methods for option pricing, such as binomial models or Monte Carlo simulations. These methods are more commonly utilized when an equity value is dependent on the price evolution of the company or when certain equity classes have features that can’t be captured with the use of Black-Scholes.
  
  While the OPM has some advantages, such as the ability to capture the option like payoff that characterizes the various equity classes in a complex capital structure, the OPM assumes a single liquidity event at a specific time. Therefore, this method cannot capture other liquidity events that may occur at different times. The OPM is most appropriate when potential liquidity events are difficult to forecast.
  
  
• The Hybrid Method – This method combines the PWERM and the OPM by estimating the probability-weighted value across multiple scenarios, incorporating the OPM to allocate values within one or more of those scenarios. The Hybrid Method is applicable in situations where an exit scenario (for example an IPO in six months) exists but is uncertain. If an IPO is anticipated in six months, the Hybrid Method might use the PWERM to base the value of the equity classes on the share prices, timing, and other assumptions fitting that scenario while using the OPM to estimate the value of each equity class in the event the IPO does not materialize. The resulting equity values under each scenario would be weighted using their respective probabilities.

Selecting a Valuation Method for Your Complex Capital Structure

As discussed above, the assumptions and complexity of the valuation methods differ one to another. The Guide, issued by the AICPA, recommends that you consider the following criteria when selecting a method for valuing equity classes:

1. The method corresponds with the going-concern status of the business by reflecting the expectations of the stockholders regarding timing, cashflow amounts, and uncertainties.
2. The method allocates value to the common stock class unless the business is being liquidated and the common stock class is not being distributed as cash.
3. The results of the selected method can be approximated by another valuation professional using the same data and assumptions. This means that the valuation method does not heavily rely on proprietary methods or data that cannot be obtained independently.
4. The complexity of the method should be in line with the development stage of the business. For example, an OPM with fewer assumptions would be more applicable and accurate when valuing an early-stage business, while a PWERM that requires developing exit scenarios, probabilities, and discount rates might be more appropriate for a mature business.

Bottom Line

There is no “one size fits all” method when allocating equity value to various equity classes. The selected methodology and its complexity depend on your company’s stage of development and its capital structure. An independent valuation firm can add value by assisting business owners, finance executives, and PE firms alike with compliance and regulatory issues, as well as preparing for strategic events, such as an acquisition, financing round, or IPO.