Valuing Ownership Interests in Companies with Complex Capital Structures
By Sean Saari, CPA, ABV, CVA, MBA, Partner, Advisory Services
It is not uncommon for private equity-funded or early-stage companies to issue equity with certain economic preferences when raising capital. The terms of equity preferences can vary widely from company to company, but the presence of multiple classes of equity in a company creates a complex capital structure that adds another step to the valuation process. When a complex capital structure is present, once the value of the company’s equity is determined, that value must be allocated to the various equity classes, a process commonly described as a “waterfall.” What many investors who hold common shares/units do not realize is that the terms of the preferred equity classes often divert a significant portion of the company’s value to the preferred investors, leaving less for those who hold common shares/units (even if the company has experienced significant growth).
The terms of the preferred equity issuances can oftentimes influence the value of the common shares/units just as much, if not more, than the underlying value of the company. The following are common preferred equity provisions that can significantly influence how much of a company’s value is left to allocate to the common shareholders/members:
It is customary for preferred equity investors to have a liquidation preference over the common shareholders/members (and possibly the holders of previously issued preferred equity classes). This preference allows for the preferred equity investors to receive the amount of their investment (or some other stipulated value, sometimes including a premium) back in the event of a sale before any remaining funds are divided among the other investors in the company. Liquidation preferences “block off” a certain amount of value for the preferred equity investors before the common shareholders/members can expect to receive any proceeds.
Complex capital structures also commonly have equity classes with an annual preferred dividend. These annual preferred dividends must be paid before the common shareholders/members can receive any dividends. Preferred dividends are often cumulative in nature, meaning that any preferred dividends not paid in one year carry over into future years. It is also a common requirement that the preferred dividends be paid in full with proceeds from a sale of the company (in addition to the liquidation preference) before any funds can be distributed to the common shareholders/members.
This can be a very impactful provision may result in unexpected and severe dilution to the common shareholders/members depending upon the company’s capital structure. “Non-participating” preferred equity investments not receive any proceeds above and beyond the liquidation preference and cumulative preferred dividends in the event of a sale. It is not uncommon, however, to see “non-participating” preferred equity investments with a conversion feature that allows those shares to be converted into common shares if the sales price is high enough to make this a more attractive option for the investor. “Participating” preferred equity investments, on the other hand, share in the proceeds remaining after the satisfaction of the liquidation preference and cumulative preferred dividends on a pro-rata basis with the common shareholders/members. Therefore, depending upon the number of preferred and common shares/units outstanding, the “participating” preferred investors can wind up leaving very little value for the common shareholders/members, even if the company’s value has increased significantly.
The preceding factors, as well as other provisions of preferred equity investments (which vary on a company by company basis), can severely impact the value of common shares/units held in an entity. It is important for common shareholders/members to keep this in mind when raising equity through the issuance of a preferred equity round. This also should be considered when stock options or profits interests are being issued since what may look like a meaningful grant to an employee could really have little value due to the claims that the preferred equity investors have on the value of the company.