Valuing Companies with Complex Capital Structures

Business Advisors|Business Valuation

By Stephen Thimons

Valuing companies with complex capital structures can be a difficult task.  In particular, how does one allocate the total value of an entity across different classes of stock/equity?

In May 2013, the American Institute of Certified Public Accountants (AICPA) issued the Valuation of Privately-Held-Company Securities Issued as Compensation (the Practice Aid), which replaced the 2004 practice aid for this subject.  The latest Practice Aid provides nonauthoritative guidance on a whole list of subjects related to issuing securities as compensation, including the valuation of equity securities in complex capital structures.

The Practice Aid lists four methods that can be used to determine the value of different types of equity securities, all of which have been in use for years:

  • Probability-Weighted Expected Return Method (PWERM) – Under the PWERM, value is determined based upon an analysis of future values for the enterprise under different potential outcomes (e.g., sale, merger, IPO, dissolution). 

For each scenario, the value determined for the enterprise is allocated to each class of stock based upon the assumption that each class will look to maximize its value.The values determined for each class of stock under each scenario are weighted by the probability of each scenario and then discounted to a present value.

  • Option Pricing Method (OPM) –­ The OPM considers common and preferred stock as call options on the company’s value.  The exercise prices used are based upon the liquidation preference of the preferred stock.  Normally, the Black-Scholes model is used to determine the value of the call options. 

The starting point of an analysis under the OPM is a determination of the company’s total equity value. From there, the OPM is used to allocate value among classes of stock. 

  • Current Value Method (CVM) – The CVM is based first on estimating the total equity value of a company assuming an immediate sale.  That value is then allocated based upon each class of stock’s liquidation preferences or conversion values.  However, because the CVM is based solely on a current value, the Practice Aid states that its use should be limited to two circumstances: (1) when a liquidity event is imminent; and (2) when a company is at a very early stage of development.
  • Hybrid Method – The hybrid method combines the PWERM and OPM.  For this method, the value of an entity is determined under multiple scenarios consistent with the PWERM, but the OPM is used to allocate the value among classes of stock within one or all of the scenarios.

The Practice Aid also discusses another, more recent, technique for determining the value of various equity types, the backsolve method.  The backsolve method is essentially a form of the market approach, where recent arm’s-length transactions in a company’s stock are used to derive the overall value of the company and each of its types of equity securities.

The name “backsolve” comes from the fact that the analysis begins with the value of one equity class and then works backwards to determine the overall company value.  The backsolve method is an iterative process whereby different total company values are used until the value of the stock recently sold equals the price paid.

This article provides a very high-level overview of the methods used to value companies with complex capital structures, while the Practice Aid provides much more detail regarding each of these methods.  All four methods should be applied carefully based upon the specific facts and circumstances of the case.  A thorough understanding of the Practice Aid and the analyses it describes there is critical before performing any valuation.

If you require assistance with the valuation of a company with complex equity securities, please contact Tom Claassen at 412.697.5330 or tclaassen@schneiderdowns.com or Steve Thimons at 412.697.5281 or sthimons@schneiderdowns.com.

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