Objectives: VALUING PREFERRED & COMMON EQUITY USING THE BACKSOLVE METHOD 5/19/2015

Transcription

1 VALUING PREFERRED & COMMON EQUITY USING THE BACKSOLVE METHOD Presented by: Bradford C. Taylor, ASA, CVA May 19, 2015 marcumllp.com Objectives: Overview of the backsolve methodology Overview of relevant rights and privileges of preferred equity Overview of the Black-Scholes option pricing model Mechanics of the backsolve model 2 1

2 History: 2004: Valuation of Privately Held Company Equity Securities Issued as Compensation issued by the AICPA Regarding companies granting stock, options and warrants to employees Corresponds to IRC 409a and FASB 123(R) (now ASC 718) 2013: AICPA updates the previous practice aid Recognizes the backsolve method as best practices 3 Definition of Value: Fair Value, which is defined in ASC 820 as: the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Fair Market Value, which is defined in Revenue Ruling as: the price at which the subject interest will change hands between a willing buyer and a willing seller when neither is under any compulsion to act and both have reasonable knowledge of all relevant facts and data. 4 2

3 Equity Allocation Methods: The Current Value Method (CVM) The Probability Weighted Expected Return Method (PWERM) The Option Pricing Method (OPM) The backsolve method is an OPM model Hybrid approach 5 Option Models: Black-Scholes Binomial Trinomial Monte-Carlo Typically, the OPM utilizes the Black-Scholes model to calculate the various call option values 6 3

4 Black-Scholes Model First published in 1973 Uses continuous mathematics Accepted by financial and legal community Leads to a precise answer Inflexible 7 Black-Scholes Model: Stock option assumptions: Current stock price Exercise or Strike Price Time to expiration Expected volatility Risk-free rate Dividend rate 8 4

5 The Value of a Call Option: Call = Max(Stock Price Exercise Price,0) A prudent investor would not exercise the option if it was out of the money Lends itself to the OPM and indifference points 9 Option Pricing Method: Treats common and preferred equity (as well as other equity claims) as having a call option on the equity value of the company. Best method to use when a specific future event is difficult to determine MUST consider the rights and privileges of all of the equity shares in the company at the time of the valuation 10 5

6 Preferred Equity Rights: Economic rights: Preference Liquidation price Dividends Conversion and/or participation Caps and/or floors 11 Preferred Equity Rights: Control rights: Voting Management Board seats 12 6

7 Backsolve Overview: The backsolve method derives the implied equity value for the company from a transaction involving the company's own securities 1 1 Valuation of Privately Held-Company Equity Securities Issued as Compensation. Paragraph American Institute of Certified Public Accountants, Inc. 13 Backsolve Overview: Based on transactions of equity securities of the company Should consider events and information that are known or knowable as of the valuation date It is forward looking 14 7

8 Backsolve Overview: According to the AICPA practice aid, the backsolve method is the most reliable indicator of the value of the enterprise at stage 1 Even more reliable in stage 2 companies Beyond stage 2, still applicable, but as the company matures, the appraiser is able to us other valuation methods Also, new investments may not be arm s length as insiders provide capital 15 Backsolve Overview: Key Assumptions: Current stock price Exercise price Time to a liquidity event Risk free rate Volatility Does this sound familiar? 16 8

9 Current Stock Price: Typically, the current stock price represents the value of the total equity of the company In the backsolve method, the appraiser uses goal seek to determine this value based upon the price of the recent financing Only AFTER all of the rights and privileges of the various equity claims have been modeled

10 Exercise Price: The exercise price is based upon a number of factors: Liquidation price Preferred preferences Dividends Exercise price of options and/or warrants Conversion price 19 Exercise Price: The appraiser calculates multiple exercise prices ( breakpoints ) Breakpoints are calculated to where an equity holder is indifferent to exercising or not Often called indifference points

11 Exercise Price: Modeling issues: If the number of options/warrants are included in the breakpoint calculation, the appraiser must remove from the breakpoint the exercise proceeds If options/warrants excluded, no adjustment is needed Method of preferred conversion Do they convert into a specified number of shares? Do they convert at a specified price? If the preferred shares participate, will they ever convert?

12 Exercise Price: Breakeven Breakeven Breakeven Breakeven Breakeven Breakeven Point# Point# Point# Point# Point# Point# Description Preferred Liquidation Preferrence Series A Conversion $1.50 Options Indifferent Series C-1 Conversion $2.00 Options Indifferent $3.00 Options Indifferent Conversion/Exercise Breakeven Point Per Share n/a $ 0.21 $ 1.50 $ 1.98 $ 2.00 $ 3.00 Liquidation Preference of A $ 3,983,342 $ 3,983,342 $ - $ - $ - $ - Liquidation Preference of B $ 21,303,001 $ 21,303,001 $ 21,303,001 $ 21,303,001 $ 21,303,001 $ 21,303,001 Liquidation Preference of C-1 $ 50,114,683 $ 50,114,683 $ 50,114,683 $ 50,114,683 $ - $ - Liquidation Preference of C-2 $ 61,569,770 $ 61,569,770 $ 61,569,770 $ 61,569,770 $ 61,569,770 $ 61,569,770 Liquidation Preference of Less: Net Effect of Proceeds from in-the-money Options/Warrants n/a - (375,000) (375,000) (1,375,000) (2,725,000) Value Allocated to Common, Options/Warrants, and Converted/Participating Preferred n/a $ 11,762,100 $ 112,842,440 $ 148,952,021 $ 202,077,479 $ 304,466,218 Equity Value at Conversion/Exercise Breakeven Point $ 136,970,796 $ 148,732,896 $ 245,454,894 $ 281,564,475 $ 283,575,250 $ 384,613, Time to Liquidity: Usually determined through discussions with management Disagreements over proper definition of a liquidity event Change of control transaction? Capital raise? 24 12

13 Time to Liquidity: Time to liquidity is an extremely important input The longer the time frame, the greater the value attributed to the lower preference equity classes. Function of the Black-Scholes model Additionally, the longer period does not consider any dilutive events or a going concern issue If the time is relatively short, a CVM may be more appropriate resulting in more value to more senior preferences 25 Time to Liquidity: OPM Related Assumptions Equity Value $ 236,527,008 Preview Risk Free Rate 0.75% Common Stock $ 1.60 Expiration in Years 3.0 Recent Round $ 2.16 Annualized Volatility 72% Annualized Dividend Yield 0% 26 13

14 Time to Liquidity: OPM Related Assumptions Equity Value $ 132,432,006 Preview Risk Free Rate 0.11% Common Stock $ 0.54 Expiration in Years 1.0 Recent Round $ 2.16 Annualized Volatility 72% Annualized Dividend Yield 0% 27 Volatility: Is a measure of how uncertain we are about future stock movements Measured as an annual change Not particularly easy to calculate for early stage companies Higher end of market participants If no high growth market participants are applicable, use a smaller set from a broader industry grouping 28 14

15 Volatility: OPM Related Assumptions Equity Value $ 139,974,373 Preview Risk Free Rate 0.75% Common Stock $ 0.60 Expiration in Years 3.0 Recent Round $ 2.16 Annualized Volatility 50% Annualized Dividend Yield 0% 29 Volatility: OPM Related Assumptions Equity Value $ 575,735,095 Preview Risk Free Rate 0.75% Common Stock $ 4.99 Expiration in Years 3.0 Recent Round $ 2.16 Annualized Volatility 100% Annualized Dividend Yield 0% 30 15

16 Dividends: Preferred dividends must be accounted for within the breakpoint calculations Do they have to be declared? When, as, and if? Cumulative? Compounding? Common dividends are not accounted for within the OPM model Typically not declared by the company 31 Discount for Lack of Control: Not typically applied The rights and privileges are factors in the model itself Can the company improve cash flows under current ownership Can a current minority owner expect better cash flows? Must examine the transaction! 32 16

17 Discount for Lack of Marketability: Junior securities are less marketable What are the different aspects of the recent financing round s equity versus other stakeholders DLOM calculations: Restricted stock studies Option models Longstaff, Chaffe, Finnerty, Asian Option Model, Differential put, etc. 33 Questions Bradford Taylor, ASA, CVA Marcum LLP 53 State St. 38 th Floor, Boston, MA P: (617) F: (617) Brad.taylor@marcumllp.com 17