By Kevin Wharton, Stephen Cuneo, Keith McGowan, Matthew Goldberg
On August 1, 2019, the AICPA released the much-anticipated Accounting & Valuation Guide, “Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies”—also known as the “AICPA Guide” or the “Guide”. Understanding the nuances of appropriate valuation methodologies is challenging and as such the intent of the following, the first of a mini-series, is to address various valuation methodologies highlighted in the AICPA Guide which are generally deployed for valuing Level III investments.
The purpose of our series is purely educational in nature and we would refer end-users to the AICPA Guide and their own unique facts and circumstances in considering the appropriate valuation methodology for the specific circumstances at hand. We will begin each series by discussing the valuation methodology, the mechanics of how the technique is intended to work, the benefits inherent in the technique, and the pitfalls of each.
The first valuation methodology we will cover in our series is the Option Pricing Model (OPM). In considering the use of the OPM for the allocation of a company’s aggregate equity value to the underlying equity securities, it’s important to reflect upon the commonly used equity allocation methods; OPM, a current value method (CVM) (i.e., a waterfall), a scenario-based method such as the probability-weighted expected return method (PWERM) and a hybrid method (i.e., a combination of a scenario-based method along with an OPM). For a detailed explanation of these equity allocation methods, please refer to Chapter 8 of the AICPA Guide.
In its purest form, the OPM is a Black-Scholes-based mathematical model that uses various inputs to calculate option strike prices (both put and call options) as of a future date. In the context of a private company’s capital structure, the OPM strives to calculate the fair value of common stock based on the total equity value of a company. The total equity value used in the OPM model is often the company’s most recent “post money” capital raise/equity financing round. A series of future call options representing various share classes, rights, and preferences are assigned a tranche of future value based on the current equity value and based on volatility, estimated time to exit, and various features of the company’s equity securities, such as liquidation preferences, and anticipated dividend payouts.
An iteration of the OPM, the “OPM backsolve”, or reverse OPM, is most commonly utilized by CFOs in the fund world. On its surface, it attempts to answer the following question: What would an enterprise’s equity value need to be for a marginal or new outside investor to invest on a per share basis, considering the company’s current equity stack, which includes all of the existing share classes with their respective seniority, rights, and preferences?
Inputs:
Counter-intuitive/Circular Reference:
Pending IPO or Strategic Exit:
OPM Mechanics & Inputs
Simply put, the OPM model relies on key inputs and the most recent post-money equity value to assign value to each preferred share class, common share class, and common share equivalents. An iteration of the basic OPM, the OPM backsolve, takes the calculation a step further and attempts to quantify the correct equity value through a number of iterations using the most recent preferred equity raise as an anchor. However, for the purposes of this series, we will discuss the basic OPM.
The following represent the key inputs that are used in the OPM calculation. A few of the key inputs into the model must be carefully considered and verified to the best of the end-user’s ability.
The inputs should be realistically assessed. As with any model, the “garbage-in, garbage-out” metaphor applies.
As stated, the end goal of the OPM is to assign equity value to each share class based on the key inputs discussed above. So, what are the mechanics of this exercise? First, using a liquidation scenario for each share class in the company’s equity structure or “stack” is assigned a “breakpoint” to demonstrate where these share classes would have value based on different liquidation or exit scenarios of the underlying company. This is performed for the most recent preferred security all the way up to the point all of the share classes are “in the money” (i.e., the intrinsic value is greater than zero) and ultimately until the last bucket is tipped – where preferred shares convert to common. Next, employing the Black-Scholes option pricing model, an implied underlying option value (using key inputs) is derived for each share class to capture the time value of the securities for the passage of time over the selected time to exit (i.e., holding period).
Exhibit A illustrates the application of the OPM with a subject company’s capital structure that includes three classes of preferred stock (i.e., Series A through C) and common stock. The use of an OPM in this example is believed to be appropriate and yields credible value indications for the subject company’s equity securities. The example utilizes the following key inputs:
Total equity value – $1,154,451 (i.e., the value of all classes of equity to be allocated amongst the classes of equity securities)
Time to exit – 5 years to a potential liquidity event
Volatility – 50% which represents the selected annual equity volatility
Risk-free rate – 2.5% which matches the time to exit/selected term of 5 years
Dividend assumption – Zero (0) dividends expected over the selected term/time to exit
Based on the key inputs above, the example yields the following per share values for the subject company’s equity securities:
Series A Preferred – $1.27 per share
Series B Preferred – $1.42 per share
Series C Preferred – $2.00 per share
Common Stock – $ 1.10
These values represent a call option strike price or what the tipping point (in terms of liquidation value) would need to be for this share class to begin accruing value. The next step is a calculation of each preferred share class’s incremental option value based on the initial option value. This begins with the preferred share’s incremental option value based on the option value less the total equity value estimate. For subsequent share classes, the previous option value is deducted from the current option value to arrive at the incremental option value for each share class. Finally, the values of all incremental option values are applied to each share class until reaching the final share class scenario of when all the buckets are filled and preferred equity would convert to common equity. The summation of the initial preferred value per share is then calculated.