Allocating Value among Different Classes of Equity: Valuation Models Can Be Tailored to Unique Financing Structures

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EXECUTIVE SUMMARY

* It is essential for board members, executive officers, CFOs, auditors and private equity investors to comprehend option-pricing models used to determine the per-share values of common and preferred shares.

* The AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes three methods of allocating value between preferred and common equity, which include:

* Current Value Method ("CVM")

* Probability Weighted Expected Return Method ("PWERM")

* Option-Pricing Method ("OPM")

* OPM, which is based on the Black-Scholes model, is a common method for allocating equity value between common and preferred shams.

* Valuation models must be tailored to the specific facts and circumstances of the equity in the company being valued.

All companies with preferred stock need to be fluent in the application of an option-pricing method since it is often used to determine the per-share value of their common or preferred securities. An understanding of option-pricing models is no longer the exclusive domain of a small group of accountants. Now, board members, executive officers, CFOs, auditors and private equity investors should have an awareness and understanding of the option-pricing models.

Today, companies are being financed with hybrid forms of capital that go well beyond plain-vanilla common equity and interest-bearing debt. It is not unusual for a business to carry debt that can be converted to equity or equity that is entitled to a liquidation preference. To complicate matters further, some rounds of financing incorporate caps, accrued dividends, performance warrants and other valuation complexities. An understanding of these financial structures and their effect on value is essential for several interested parties:

* Valuation analysts need to understand the ramifications of a company's capital structure on the value of its equity securities.

* Executive management needs to know the effect that a round of financing may have on the fair value of a company's existing securities and capital structure.

* Private equity investors need to understand the effect that their investment has on the fair value of other equity securities in order to better structure their transactions.

Accordingly, we have presented an example to help valuation analysts, senior executives and investors through the structured-finance maze.

ALLOCATING EQUITY VALUE BETWEEN DIFFERENT CLASSES OF EQUITY

In 2004, the AICPA released its Practice Aid titled Valuation of Privately-Held-Company Equity Securities Issued as Compensation (please note that due to changes made to professional standards since this practice aid was originally issued, it is out of print and no longer available for purchase through the AICPA Web site). The guide summarizes many of the valuation standards and procedures that have been adopted by the profession. The guide also describes three methods of allocating value between preferred and common equity, which include:

* Current Value Method ("CVM")

* Probability Weighted Expected Return Method ("PWERM")

* Option-Pricing Method ("OPM")

The CVM has practical limitations on its use. Specifically, it should be used in two cases: (1) when a liquidity event is imminent and (2) when the business is at such an early stage of development that there is no material progress on the company's business plan and there is no reasonable basis to estimate value beyond the preferred preference.

The PWERM is especially difficult to apply due to the significant level of subjectivity it requires. The probability of various exit scenarios and the value of the business at such exit events is very difficult to support.

As a result, the OPM is a commonly used method for allocating equity value between common and preferred shares. …