Valuing Early Stage Companies with Complex Capital Structures

Written by: Eli C. Neal, CPA, ABV, CFF

In Portland, Oregon and around the United States, early-stage companies are raising hundreds of millions of dollars in the beginning of their life cycle. Investment firms, private equity firms, and venture capital funds are keen to invest millions of dollars into the next great idea. Companies can receive a major investment with no revenue – or even without a working product. For early-stage companies – especially those that have yet to start generating earnings – all the value rests on future potential.

Valuing early-stage companies is challenging because the range of outcomes is wide, and the timing of cash flows is uncertain. Early-stage companies may become wildly successful or go out of business. Further complicating matters, there is rarely relevant historical financial information to inform future expectations.

Without historical performance to reasonably inform the future, the Discounted Cash Flow method (“DCF”) is typically most appropriate for valuing early-stage companies.

• Future cash flows

• Discount rate

• Likelihood of survival

• Discounts for lack of marketability

We start with the projections that were given to investors, if still appropriate, and look for public company comparables to determine the discount rate, if similar companies exist. Typically, the projections and discount rates used in the DCF reflect the survival scenario. To understand the likelihood of failure, we interview management and research the industry to make our best estimate about the probability of survival.

After determining the company’s equity value using the DCF, the value needs to be allocated to the individual shares. This is a straightforward exercise if the ownership structure is comprised of shares that all have the same rights or even if some shares are voting and non-voting. In most companies we value, the share value is pro rata of the whole, adjusted for discounts for lack of control or lack of marketability.

For early-stage companies with complex capital structures, translating equity value into share value requires a systematic process. Today, capital structures can include liquidation preference, share conversion, time vesting options, performance vesting options, options with an exercise price, convertible debt, etc. The Option Pricing Model (“OPM”) was developed to reliably estimate the value of different economic rights in complex capital structures.

Mercer Capital developed a fantastic explanation of the OPM titled, “A Layperson’s Guide to the Option Pricing Model.” The allocation of equity value is important because financial engineering and complexity do not create additional value. As the treatise states, “creative pie-slicing does not make the pie any bigger.” The OPM process is rooted in the initial equity valuation but allocates the value based on the varying capital components.  

The equity value is allocated by modeling the various capital structure components as a series of call options. The first step is to model how proceeds would be distributed amongst the share classes in the event of an asset sale. When the allocation of proceeds to the various share classes changes, it is referred to as a “breakpoint.” The cashflows between each breakpoint are called “tranches.” Each tranche is modeled independently as if the total proceeds received in an asset sale is within that tranche.

By identifying the breakpoints, the valuation professional can use the Black Scholes Model to value each specific tranche as if it were a call option. The value of each tranche is then allocated based on how the proceeds would be distributed to the share classes within that tranche. The value of each share class is calculated by summing the allocated value of each tranche

The OPM is attractive because of its precision, small number of assumptions, low sensitivity, and auditability.

The OPM can also be used to value the equity by employing the Backsolve Method. The Backsolve Method uses the last funding round as the input in the valuation. For example, if a company had just raised $10 million at $10 per B Share, then we can surmise that $10 per B share is a good approximation of fair market value. The Backsolve Method relies on the same breakpoints, tranches, and call option modeling described above but starts at $10 per B share and works backward from the output to arrive at an indication of implied total equity value. The Backsolve Method can be used to value the other share classes or as a cross-check on value when compared to the DCF model.

Interests in complex, early-stage companies may need to be valued for a variety of reasons: gift and estate tax purposes, shareholder buy-out, shareholder dispute, or lost business value lawsuits. The DCF, OPM, and Backsolve Method allow the valuation professional to help the parties by arriving at an equity value that is rooted in valuation theory and replicable.

If you or your client have an ownership interest in a complex, early-stage company and need it to be valued, Cogence Group would be happy to assist! We have decades of valuation experience and are all CPAs. Please give us a call at 503-467-7903!