If the subject company’s capital structure is highly leveraged or consists of security classes(preferred & common) more complex than plain-vanilla equity and debt, then the valuation professional must apportion Enterprise Value to each security class based on its rights and preferences. In this article we discuss various equity allocation approaches and outline their strengths and weaknesses as discussed below.
Current Value Method
Current Value method is also referred to as “waterfall” and it is the most straight-forward method to allocate value and does not involve any complexity. The enterprise value determined as of the valuation date is allocated to different classes of security based upon their rights and preferences. There are two circumstances when CVM can be applied:
1. The liquidity event is imminent and the company is sold at the valuation date.
2. The company is in the nascent stage of development and has not started earning significant revenues as there is no progress made to business plan.
Option Pricing Method
The Option Pricing Method (OPM) is the most commonly used allocation method because of its ease of implementation. It treats common and preferred class stock as European call options on the company’s enterprise value. The exercise price of each call option are based on the preferred stock’s liquidation rights & preferences and the value points at which equity holders will make decisions regarding their participation in the value. The OPM is most appropriate to use when future outcomes are not possible to predict and the liquidity event is not imminent.
Probability-Weighted Expected Return Method (“PWERM”)
The PWERM is a package of CVMs where multiple potential exit scenarios are considered. Equity Value is derived by discounting & weighting each potential exit scenario i.e. IPO, merger or sale, dissolution, or continued operation as a private, at an appropriate discount rate. The analysis addresses the timing and probability weighting of each scenario.
Common Stock Equivalent (CSE)
It is a very simple method as it treats every share same while valuing and allocating equity value of the company. It allocates the equity value derived assuming full conversion of preferred shares into common stock at the applicable conversion rate. It is mainly used in case where the exit scenario is an IPO or the indicated value of the company is more than all liquidation preferences of shareholders.
As discussed above, some allocation methods may seem superior to others, however such superior methods are typically more complex and difficult to corroborate. There is no equity value allocation method that takes into account all rights of preferred stockholders, the effect of only certain of the various preferred stock rights is considered under the available methods and the reason for this appears to be related to the complexity and the nature of some of the rights.
See at LinkedIn…