Startup companies don’t just disrupt established industries, they add great complexity to ecosystems that support their growth. Among countless supporting functions, valuation services had to up the game.
We are not talking about online valuation tools (or SaaS-like offerings), most of which are fantastically dumbed-down versions of Excel models pretending to be AI (we have one here). The challenged are the basic valuation methods that used to be sufficient for most industries, but now come up short.
The complexity is two-fold:
1. The primary concern is to value an early-stage enterprise when financial information is too limited to perform a traditional analysis.
2. The second issue is to adequately value various types of privately-held company securities while taking into account their diverse economic and legal rights. This is the topic of this article.
Why complex capital structure
The needs of VC investors can not be served with just common stock. In exchange for substantial long-term investment of funds and human capital, VCs need to ensure they maintain control, minimize downside, while leaving enough upside to make the lottery of startup economics work for LPs. In short, their risk profile is different from that of the common shareholders.
Consider this example. You and your cousin inherited a car wash (“CW”) with 50-50 ownership split. Each dollar of profit is equally divided, regardless of how many dollars there are. Simple? Maybe too simple.
What if your cousin has 6 kids to feed and wants to preserve the value of her stake. You are an optimist, believing that the CW can do three times better. 50-50 ownership is fair, but your cousin doesn’t like the risk and wants to sell the business. You need a mechanism that will allow you to split the risk while [this is the hard part] keeping value divided on a 50-50 basis.
So here comes the complex capitalization structure. Your cousin still wants upside. You agree to develop and sell the CW after 3 years. She would get the first $1 million from the sales price in exchange for fewer shares, say 30-70 split (the “Deal”).
How do we know if this is fair, i.e. the value of each cousin’s ownership is still split 50-50, even though you have more shares? For reference, collateralized debt obligation at the heart of the 2008 financial crisis had the same issue. CDO models were there, proactively ignored.
Option pricing method
The only fundamentally sound way to ensure that VC has invested at the right valuation is to measure the fair value of its equity stake on a post-money basis. It is the same problem you and your cousin are facing; they need to ensure that post-deal stakes are still valued 50-50.
We need a method that can value options because the key element of the Deal, getting paid the value above a threshold, looks a lot like a plain stock option.
CW value (“CWV”) can go up or down, but not below zero. Your payout starts accruing after the CWV exceeds a certain threshold (“exercise price”). The value of getting every dollar above the $1 million exercise price can be estimated using Black-Scholes Merton (“BSM”) formula, just like the value of a regular stock option.
Let’s assume the CWV is $3.0M at the time of the agreement. Critically, we always need to know the value of the business, see #1 above. Below are the summaries of how much each party receives once the CW is sold (in the future), and what is the present value of such opportunities (today). Let’s assume that the value of an option, estimated with BSM formula, to buy the business for $1M in three years is $2.1M.
|Deal Payouts (upon exit)||CWV < $1 million||CWV > $1 million|
|You get||0% of CWV||70% * (CWV – $1M)|
|Cousin gets||100% of CWV||30% * (CWV – $1M)|
Valuation (today, in millions)
CWV < $1 million
CWV > $1 million
|Scenario Value||$0.9||BSM ($1M) = $2.10||$3.00|
|Your Share of Value||$0.0||$2.1 * 70% = $1.47||$1.47|
|Your Cousin’s Share of Value||$0.9||$2.1 * 30% = $0.63||$1.53|
Note that your cousin ends up with $1.53M in value and your share is $1.47M. So even though you own 70% of all shares, your cousin’s shares are better. Your share in terms of value, the ultimate measure of fairness, is only 49% ($1.47M / $3.00M).
|Percent Stake Based On||You||Cousin|
|Fully Diluted Shares||70%||30%|
We have just outlined the basics of the Option Pricing Method (“OPM”). It can account for multiple tranches of equity, especially preferred, as well as the value dilution coming from outstanding options and warrants. The method incorporates such inputs as liquidation preferences, participation rights, conversion rights, and dividends. It does not value legal attributes such as voting rights or board seats.
There has been certain amount of criticism around OPM approach. Some believe that the BSM formulas were designed for publicly traded stock options and don’t work well for illiquid long-term equity stakes in venture backed companies. Others note that capitalization table change overtime making a current cap table less relevant.
Many of those highly critical of OPM forget that it is just a tool to assess and estimate, not a definitive solution for your child’s quadratic equation homework; none of the valuation methods are.
Besides, alternatives are meager. Any calculation that attributes the same value to every share can be dangerously wrong, as demonstrated above. Scenario based methods are too sensitive to a myriad of highly subjective assumptions and lack any sense of definitiveness. And then there are stochastic simulations that will make you feel like you are financing a valuation startup, not a new cancer therapy!
We believe that OPM is a great, deterministic, useful, and essential tool in pricing equity transactions within complex capitalization tables. While an overall enterprise value remains to be the main, difficult to estimate input into the OPM model, those who avoid OPM do so at their own peril.