Valuation Issues when Appraising Companies with Complex Capital Structures
Author: Rand Gambrell
Valuation, by its very nature, can be a nebulous task. Determining a company’s value in the absence of an actual transaction can be equal parts science and art. As difficult as valuing an entire company can be, what about when only a portion of the company or a single asset or single class of stock is being valued?
This is the situation encountered when valuing shares of stock in a company with a complex capital structure. The company may have several classes of preferred stock, profits interests and stock options, resulting from multiple rounds of investment from independent companies (such as private equity firms). The company also may have different classes of common stock, such as voting and nonvoting shares—the remnants of its original capital structure when the company was owner-operated. Each of these stock categories would receive a portion of the company's equity value in the event of a sale. Alternatively, each of these stock classes is allocated a portion of the company’s equity value when the entire company is valued.
The valuation question becomes, “How much?”
For purposes of this article, assume our example company has this complex capital structure:
In this example, assume the Series A preferred stock has a liquidation preference of $2.5 million (senior to all other shares) and the Series B preferred has a liquidation preference of $5 million (senior to the common shares). After the $7.5 million Series A and Series B liquidation preference is paid, the common stock is allocated all value up to $10 million. Any value above $10 million is allocated to the shares on a proportionate basis (based on the number of shares). Finally, assume the company’s equity value has been determined to be $10 million and it carries no long-term debt.
Proportionate Value Calculation
Based on the above assumptions, absent any differences in legal or economic rights, each of the company’s shares would have a proportionate value of approximately $870 ($10 million/11,500 shares).
However, as indicated above, differences exist between the legal and economic rights of the various share classes. As a result, a different methodology is needed to value the different shares.
Current Value Method
Under the current value method (CVM), an immediate sale of the company is assumed, with the resulting value allocated to the share classes based on their liquidation or conversion value.
Using the previously discussed assumptions, the allocation of the $10 million equity value (also assumed to be the company’s sales price in this example) is allocated as follows:
Under this approach, the shares received the following allocated value:
- Series A preferred, $5,000 per share
- Series B preferred, $5,000 per share
- Common A and common B, $250 per share
The benefit of the CVM is its straightforward nature. The company’s value is determined at the current valuation date, based on the assumption the company will be sold on that date; the equity value then is allocated to the share classes based on their rights and preferences.
The model’s limitation is that it’s very sensitive to changes in the underlying assumptions. For example, based on a $10 million equity value, the common shares have a value of $250 per share. However, if the value of the company’s equity was instead assumed to be $9 million (a 10 percent decline), the value of the common shares declines to $150 per share. This represents a decline in the value of the common shares of 40 percent. In addition, this type of valuation approach fails to recognize the upside potential of the share classes (which gives the shares option-like features).
For these reasons, the CVM generally is not used, except when sale of the company is imminent or in situations involving early-stage companies in which little or no common equity value has been created.
Probability-Weighted Expected Return Method
Another method of determining the value of a company’s share classes is the probability-weighted expected return method (PWERM). Using this method, the company’s value is estimated based on various outcomes, e.g., sale of the company in one, three or five years. This value is allocated to the share classes based on the assumed outcome, weighted for probability and then discounted to present value. This model* is illustrated as follows:
As identified above, the PWERM results in additional value being allocated to the Common A and Common B shares. This is due to the probability of a company sale resulting in additional sales proceeds (value) being received by the common shares in addition to what they would receive assuming an immediate sale (the assumption incorporated in the CVM).
The PWERM model allows for robust modeling, incorporating the results and resulting value of multiple possibilities. The PWERM also allows for the inclusion of interim (operating) cash flows as well as anticipated sales proceeds. In addition, unlike the CVM, the PWERM is not as sensitive to changes in assumptions, including the assignment of probabilities to the various possible outcomes.
However, the PWERM model can be difficult to implement. In addition, the assumptions included in the model, e.g., anticipated enterprise value/sales proceeds at time of sale or timing of a sale or liquidity event, can be somewhat subjective and difficult to support. Finally, the application of a PWERM is not appropriate for valuing instruments with option-like payoffs, such as common stock options, profits interests or warrants. These instruments are more properly valued through the application of an option-pricing method (OPM).
Under an OPM, the various share classes are treated as call options on the company’s equity value (a call option gives the holder of the option the right, but not the obligation, to purchase a share of stock at a specified date and price).
Under the OPM, the company’s current value is considered (which addresses one of the criticisms of the PWERM approach). As a result, common stock only has value if funds available for distribution are greater than the liquidation preferences of the other classes of stock.
Here is an OPM* example:
Based on the above example, the per-share value for the various share classes is as follows:
- Series A preferred, $5,705 per share
- Series B preferred, $3,249 per share
- Common A and common B, $390 per share
The OPM’s strengths include the fact the model begins with the company’s current equity value and estimates distribution of outcomes around that value, unlike the PWERM, which requires the analyst to estimate the company’s future value. In addition, the OPM explicitly recognizes option-like payoffs of various share classes. Finally, the OPM can be used to value the entire equity value in a company based on a third-party minority interest sale of one of the share classes (the “back solve” method).
OPM weaknesses include sensitivity to changes in the model’s underlying assumptions, especially volatility. Other weaknesses include difficulty in incorporating assumptions about early exercise of preferred shares. In addition, similar to the CVM, the OPM considers only a single liquidity event. For this reason, a hybrid method is sometimes used that combines the PWERM and OPM; various sale scenarios are assumed, similar to the PWERM example above, which are then modeled with an OPM. This hybrid approach offers the analyst the benefits of both approaches.
As we said, valuation can be a difficult task, even in the best of circumstances. However, the valuation methods and models covered in this article can provide useful and powerful tools to assist appraisers or management as they attempt to unwind a company's value.
For more information about these topics, contact your BKD advisor.