The 409A Valuation of a private company with a complex capital structure (presence of both preferred and common stock) ultimately involves two steps:
Step 1 – Estimate Equity Value
All valuation techniques can be divided into one of either three approaches - Asset or Income or Market - with numerous methods under each approach. The following is an overview of the primary valuation approaches and methods considered in each 409A Valuation.
The Asset Approach involves estimating the market value of all a company’s assets and liabilities (both recognized on the balance sheet and other unrecognized, such as internally developed assets, goodwill, etc.); the equity value is the net value of assets and liabilities.
The Income Approach involves converting an expected future economic benefit stream (cash flows) to a single net present value by applying an appropriate risk-adjusted discount rate.
Discounted Cash Flow Method – The financial forecast is used to develop the net cash flow to debt and equity holders then discounted to the present using a company’s estimated weighted average cost of capital.
The Market Approach involves applying and adjusting market prices of comparable assets, liabilities, or businesses to the subject interest based on financial and non-financial metrics.
Guideline Public Company Method – The equity and enterprise value of selected comparable publicly-traded companies then valuation multiples are derived based on key financial metrics, such as revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), and others. Then the valuation multiples are adjusted/assessed based on differences between the guideline companies and the subject company.
Guideline Company Transaction Method – Merger and acquisition transactions of comparable companies (either public or private) are utilized to derive valuation multiples, which are adjusted/assessed based on differences between the target companies and the subject company.
Subject Company Transaction Method – The equity value of the subject company is derived based on one or more transactions in the subject company’s equity. Most typically, the subject company transaction (also referred to as the “back-solve”) method is applied following a financing round and involves utilizing the selected allocation method to solve for the equity value that results in an amount being allocated to the newly-issued equity consistent with the purchase price.
The selection and application of the various valuation approaches and methods will depend on the facts and circumstances as of the valuation date and may include more than one indication of value. The selected valuation approaches and methods will often vary from valuation to valuation update based on the maturity of the subject company, as well as the occurrence of financing rounds over time.
Step 2 – Allocate Equity Value
After determining the equity value of the subject company, one of several methods is selected to allocate the value among the various equity classes recognizing the economic rights of each.
The Current Value Method (CVM) assumes an imminent distribution of the subject company’s value (represented by the equity value) based on the liquidation rights and preferences of each equity class.
The Option Pricing Method (OPM) is the most commonly selected and applied, but also the most difficult to understand (even for an otherwise experienced and well-qualified valuation specialist). Ultimately, the method relies upon option pricing theory to value the claim of each equity class on the subject company’s future equity value, which is assumed to have a log-normal distribution. For example, the common stock can alternatively be viewed as a call option on the subject company’s equity with an exercise price equal to the total liquidation preferences of the preferred stock (e.g., common stock participates in any future distributions above the preferred stock liquidation preferences).
The Probability Weighted Expected Return Method (PWERM) involves identifying discrete liquidity events, such as an acquisition or IPO, and estimating the corresponding future equity value, timing, and probability of each liquidity scenario. The OPM is often incorporated in at least one scenario to capture the uncertainty of potential liquidity events and associated future equity values and probabilities.
The Hybrid Method involves combining two of the above methods together, typically involving the OPM.
In our experience, the appropriate allocation method will evolve with the subject company, such as the following:
Inception (Pre-Seed) Stage - CVM
Early Stage - CVM and/or OPM (Hybrid)
Expansion Stage - OPM
Late Stage - OPM and/or PWERM (Hybrid)
After allocating the equity value, certain premiums or discounts (addressing discounts, particularly the discount for lack of marketability, requires its own article) are applied to derive the value of the subject equity interest (typically common stock).
Please note that the above discussion was intended for informational purposes only and not intended as guidance in any manner. Any valuation performed by Concept Analytics LLC may diverge from the above discussion in any manner and will ultimately be dependent on the facts and circumstances as of the subject valuation date for the subject company.