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“Valuation of Privately Held Company Equity Securities Issued as Compensation” (the “Cheap Stock Guide”)
• Developed by AICPA staff and the Equity Securities Task Force.
• Originally issued in 2004 with an updated version released in 2013.
• Developed relative to ASC 718, Compensation—Stock Compensation. However, applicable for a wide variety of contexts
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The “Cheap Stock Guide”
Estimating Enterprise Value
1. Income Approach• Discounted Cash Flow Method (“DCF Method”)• Capitalization of Cash Flow Method
2. Market Approach• Merged and Acquired Company Method (“M&A Method”)• Guideline Publicly Traded Company Method (“GPTC
Method”)
3. Asset Approach
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Estimating Enterprise Value
Allocating Enterprise Value
1. Current Value Method (“CVM”)
2. Probability Weighted Expected Return Method (“PWERM”)
3. Option Pricing Method (“OPM”)• Black-Scholes Option Pricing Method (“BSM”)• Binomial Option Pricing Model (“BOPM” or “Lattice” Model)
4. Hybrid Method
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Allocating Enterprise Value
Current Value Method (“CVM”)
CVM Overview• Waterfall of enterprise value across capital structure
• Used only to allocate value across the securities, not to estimate enterprise
value.
• Used under two circumstances:
Company is in very early stages of development
A liquidity event is imminent
CVM Steps
1. Estimate enterprise value
2. Allocate value based on simple waterfall
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Complex Capital Structures:Payoff Diagram ExampleCompany: XYZ, Inc.
> Equity securities: (a) 60,000 shares of common stock and (b) 40,000 shares of convertible preferred stock having total liquidation preference of $7.5 million (non-participating, convertible to common shares at a 1:1 ratio).
> Projected sale of the company: 3 years after valuation date.
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Probability Weighted Expected Return Method (“PWERM”)
PWERM Overview• Similar to CVM in that it uses waterfall approach, but applies
across multiple scenarios• Can be used to estimate enterprise value and allocate value
across securities• Appropriate when management can reasonably predict
potential exit outcomes and exit is expected to occur in the relatively near term
• Generally not considered appropriate for valuing options, profits interests, or warrants
• Not considered appropriate for early stage companies
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PWERM Steps:1. Select exit scenarios2. Estimate future enterprise values for each scenario3. Waterfall future enterprise values4. Discount future cash flow to subject investments to present
value5. Assign probabilities to each scenario value6. Estimate share value by summing the probability-weighted
outcome of each scenario
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Probability Weighted Expected Return Method (“PWERM”)
PWERM (cont.)Payoff Diagram ExampleCompany: XYZ, Inc.
> Equity securities: (a) 60,000 shares of common stock and (b) 40,000 shares of convertible preferred stock having total liquidation preference of $7.5 million (non-participating, convertible to common shares at a 1:1 ratio).
> Projected sale of the company: 3 years after valuation date.
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PWERM (cont.)
PWERM Example: XYZ, Inc.
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XYZ, Inc.PWERM Analysis$ in 000s, except per share amounts
Scenario ($ in 000s) I. M&A Sale High II. M&A Sale Low III. Dissolution
Probability of Liquidity Event 45% 45% 10%Time to Liquidity (year) 3.0 3.0 3.0Enterprise Value at Liquidity Event 25,000$ 10,000$ 3,000$
less : Net Debt at Liquidity Event - - - Equity Value 25,000$ 10,000$ 3,000$
Distribution per Share (Future Value) I. M&A Sale High II. M&A Sale Low III. DissolutionSeries A Convertible Preferred Stock 250.00$ 187.50$ 75.00$ Common Stock 250.00$ 41.67 -
Discount rate 40% 40% 40%Present Value Factor 0.364 0.364 0.364
Fair Value per ShareDistributions per Share (Present Value) (probability-weighted)Series A Convertible Preferred Stock 91.11$ 68.33$ 27.33$ 74.48$ Common Stock 91.11$ 15.18$ -$ 47.83$
• OPM is used to allocate value, not estimate enterprise value (unless can backsolve)
• BSM is generally more commonly applied than BOPM• OPM is most appropriate when little visibility to exit• Think of an BSM as a PWERM with infinite exit scenarios and
BOPM as PWERM with a ton of exit scenarios
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OPM (cont.)
BSM Steps:1. Estimate enterprise or equity value (using income / market /
asset approach)2. Determine strike price for each option tranche3. Estimate projected exit date (sale of company, IPO)4. Determine other key inputs for the Black-Scholes formulas
5. Calculate value for each tranche using Black-Scholes6. Allocate value of each tranche across the capital structure of
the company
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OPM (cont.)Payoff Diagram ExampleCompany: XYZ, Inc.
> Equity securities: (a) 60,000 shares of common stock and (b) 40,000 shares of convertible preferred stock having total liquidation preference of $7.5 million (non-participating, convertible to common shares at a 1:1 ratio).
> Projected sale of the company: 3 years after valuation date.
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OPM (cont.)
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OPM Example: XYZ, Inc. (figure 1 of 2)XYZ, Inc.OPM: Indication of Option Values$ in 000s
Equity value is $0Tranche 1
preferred stock receives
liquidation preference
preferred stock converts
to common stockTranche 3
Value of Equity [a] 5,000$ 5,000$ 5,000$ Exercise Price [b] -$ 7,500$ 18,750$ Years until exit [c] 3.0 3.0 3.0Volatility [d] 60% 60% 60%Dividend Rate [e] 0% 0% 0%Discount Rate [f] 0.88% 0.88% 0.88%
Call option value 5,000$ 1,536$ 544$ Incremental value of options 3,464$ 992$ 544$
Footnote:
[f] Discount rate is based on treasury yield as of the Valuation Date with maturity equal to term.
[a] Total equity value of the Company.[b] Exercise price is derived based on enterprise value at which the given security would reach their liquidation preference or at which a holder of the security would opt to convert.[c] Expriation is based on Company management's assumption of exit scenario timeline, market analysis, and [d] Volatility is the estimated annual standard deviation of the Company's equity value, as estimated based on the annual standard deviations observed for the guideline publicly traded companies selected.[e] Based on management's projections.
OPM (cont.)
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OPM Example: XYZ, Inc. (figure 2 of 2)
XYZ, Inc.OPM: Indication of Option Values$ in 000s
Tranche 1 - 2 Tranche 2 - 3 Tranche 3 - 4 TotalFair Value Per
> Good for estimating value when reasonably good visibility to an exit> More directly models investment exit outlook than OPM> Aligns with the boom or bust dichotomy of certain types of
companies
• Weaknesses: > Highly subjective inputs> Not a lot of standardized guidance> Prone to management bias – needs to be validated with empirical
> Good for estimating value when outcomes are difficult to estimate> Inputs can be audited> Better than PWERM at valuing options> Fair amount of standardized guidance
• Weaknesses: > Doesn’t model skewed distributions well> Less intuitive for the layperson / client than PWERM
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OPM Strengths and Weaknesses
Hybrid Method
The Hybrid Method
• The Hybrid Method utilizes the PWERM, using the OPM to allocate value within one or more scenarios
• Useful when company has transparency into one or more near term exits, but unsure about what will occur if those don’t obtain.
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Backsolve Method
Backsolve Method• Uses transaction in a security to value the other
securities issued by the company• Can be applied under OPM or PWERM• Value of the enterprise is imputed from security
transaction price• Caveats; may not be appropriate if
• Non-arm’s length• Strategic investment
• Backsolve Method should be supported by other methodologies
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Debt
Debt:• Valuing debt is critical to valuing equity• Yield Method
• Value of debt = present value of all cash flows discounted at a market yield.
• Market yield estimated using synthetic rating analysis• Yield on the debt when originally issued is used as baseline (if arm’s
length).• Yield at original issuance date = risk-free rate + credit spread +