Drafting Considerations for Attorneys Blog Series – Complex Capital Structure Equity Valuation
By Sean R. Saari, Partner, Advisory Services
The fields of law, accounting and valuation are only continuing to become more complex. Given the overlap in these areas of specialty, it is increasingly important for attorneys to have an understanding of the accounting, tax and valuation effects of the legal agreements they draft. Armed with this knowledge, lawyers can produce the intended outcome for their clients and minimize unintentional consequences and compliance burdens.
Complex capital structures are those with multiple classes of equity with different rights and preferences – typically preferred and common stock – which are most often seen in companies with private equity or venture capital investors. The “waterfall” outlined in the corporate governance documents determines how the proceeds from a sale are allocated amongst the various equity classes. While the waterfalls and capital structures of companies with preferred and common shares may have certain similarities, each is unique based on the provisions outlined in a company’s corporate governance documents. As a result, the VALUATION of companies with complex capital structures is more involved than valuing a company with a single class of stock.
Preferred Share Preferences
In addition to voting power, preferred shareholders typically have a number of economic preferences that are not shared by the common shareholders:
- Liquidation Preference – The preferred shareholders get their original investment back before the common shareholders receive any proceeds.
- Preferred Dividends – The preferred shareholders receive a guaranteed annual dividend on their investment.
- Conversion Rights – The preferred shareholders are able to convert their ownership interest into common shares if it is more beneficial for them.
- Participation Rights – The preferred shareholders share in any proceeds remaining after the satisfaction of the liquidation preference and preferred dividends on a pro-rata basis with the common shareholders.
Equity Valuation of Companies with Complex Capital Structures
Valuing the equity of companies with complex capital structures is best described as just that – complex. While the valuation of the total equity of a company with a complex capital structure is no different than any other company, there are significant differences (and complexities) in how that value is allocated across the various equity classes. Simply subtracting the preferred share liquidation preference and accrued dividends will not produce an accurate value of a company’s common equity if a sale transaction is not imminent. The AICPA has actually released guidance stating that this approach to valuing a company’s common equity (called the “Current Value Method”) is not appropriate if a sale is not imminent.
The following methods have gained acceptance for allocating the equity value of a company with a complex capital structure when a sale is not imminent, which allow for the modeling of the economic preferences of each class of stock:
- Option Pricing Method (“OPM”) – The value allocated to each equity classes is determined using an option-based analysis.
- Probability-Weighted Expected Return Method (“PWERM”) – The values allocated to each equity class under a variety of potential exit scenarios are determined, discounted to the valuation date and then weighted based on their expected probability of occurrence.
Just because a company’s common stock may be “underwater” as of the valuation date based on the Current Value Method, an OPM or PWERM model may still allocate some value to the common shares.
It is also important to note that because of the difference in preferences between common and preferred stock, the per share value of a recent preferred stock issuance will likely not provide an accurate indication of the per share value of a company’s common stock. This is very relevant when setting the strike prices for newly-issued stock options. If the strike price for a common stock option is based on the per share value paid in a recent preferred share issuance, the strike price will likely be significantly in excess of the actual value of the common stock. While this does not create a 409A issue (in fact, it lowers the risk of 409A non-compliance), it may require appreciation of the company far in excess of management’s expectations before the options are “in the money.” This can result in unhappy employees that think they may be receiving something of material value when the options are granted, but which really have a reduced likelihood of having any value upon exercise due to the inflated strike price.
Continue reading about the key accounting, tax and valuation considerations of buy-sell agreements in our e-book: Drafting Considerations for Attorneys: Buy-Sell Agreements, Accounting, Tax and Valuation Issues. Have a question about capital structure equity valuation? Contact Sean Saari at 440-459-5700.