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Valuing Securities in Complex Capital StructuresJanuary 13, 2016

Presented by:Paul Daddio, CFA, ASASenior Manager703-923-8562paul.daddio@bakertilly.com

Presentation Outline• The “Cheap Stock Guide”• Estimating enterprise value• Allocating enterprise value• Backsolve Method• Debt

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Presentation Outline

“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$

The Option Pricing Method (“OPM”)

OPM Overview• Two methods:

• Black-Scholes Option Pricing Method (BSM)• Binomial Option Pricing Method (BOPM or “Lattice” Method)

• 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

• Volatility• Risk-free discount rate• Dividend yield

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

Share

Liquidation Preference ($000s) / Shares Liquidation Preference Shares Shares

Series A Convertible Preferred Stock 7,500$ 0 40,000 Common Stock 0 60,000 60,000 Total 7,500$ 60,000 100,000

% of Liquidation Preference / SharesSeries A Convertible Preferred Stock 100.0% 0.0% 40.0%Common Stock 0.0% 100.0% 60.0%Total 100.0% 100.0% 100.0%

Allocation of Value ($000s, except per share)Series A Convertible Preferred Stock 3,464$ -$ 218$ 3,682$ $92.05Common Stock - 992 326 1,318 $21.97Total 3,464$ 992$ 544$ 5,000$

Binomial Option Pricing Model (BOPM or “Lattice” Model)

Lattice Model• Essentially the same conceptually as BSM

(same inputs as well)• Models future value as progression of value

nodes from valuation date to exit. Value equals probability weighted PV of exit values.

• Strength: good for modeling discrete events (real options, financing rounds, etc.)

• Weakness: assumptions regarding the terms and conditions of future financing rounds are difficult to estimate

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Binomial Option Pricing Model (BOPM or “Lattice” Model)

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Lattice Model$ in 000s

0 1 2 3 4 5 6 7 8 9 10 11 12

Value of current equity 166$ 325$ 618$ 1,127$ 1,928$ 3,556$ 5,108$ 7,215$ 10,062$ 13,909$ 19,105$ 26,123$ 35,598$ 43 98 225 513 1,577 2,391 3,530 5,089 7,196 10,043 13,890 19,086

0 0 0 585 961 1,532 2,359 3,511 5,069 7,176 10,0230 0 163 297 526 903 1,489 2,340 3,492 5,050

0 29 60 121 237 455 842 1,470 2,3203 6 13 30 69 157 360 822

0 0 0 0 0 0 00 0 0 0 0 0

0 0 0 0 00 0 0 0

0 0 00 0

0

Period

PWERM Strengths and Weaknesses

PWERM• Strengths:

> 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

market evidence> Requires handicapping future events requiring estimation / guessing

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OPM• Strengths:

> 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 +

subordination premium / company-specific risk premium

• OPM• Applicable for companies with extreme leverage

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