By Christian Sivel | Withum, AAML NJ Gold Sponsor
Early-stage companies can often be more challenging to value than an established business. This is due to several different variables most namely stage of enterprise development, types of equity issued and methodology used. Below we will outline a number of considerations, what to expect during the valuation of an early-stage company and an overview of the Option Pricing Model (“OPM”) commonly used for early-stage company valuations.
Stages of Enterprise Development:
The stage of operational development of an enterprise is an important determinant of the value of the enterprise and an indicator for which approach or approaches for valuing the enterprise are generally more appropriate. The AICPA defines six stages of enterprise development as follows:
Stage 1 – Enterprise has no product revenue to date and limited expense history and, typically, an incomplete management team with an idea, plan, and possibly some initial product development. Typically, seed capital or first-round financing is provided during this stage and securities issued are more commonly in the form of preferred stock. The Backsolve Method is the most reliable indicator of value of the enterprise at stage 1, if relevant and reliable transactions have occurred in the enterprise’s equity securities.
Stage 2 – Enterprise has no product revenue but substantive expense history, because product development is under way and business challenges are thought to be understood. A second or third round of financing typically occurs during this stage. The typical securities issued to those investors are in the form of preferred stock. The Income Approach (e.g., DCF method) will likely be more relevant than in stage 1; however, the enterprise may still have significant difficulty in forecasting cash flows. As such, valuation specialists may choose to use the income approach during stage 2 as a secondary approach.
Stage 3 – Enterprise has made significant progress in product development; key development milestones have been met (for example, hiring of a management team); and development is near completion (for example, alpha and beta testing), but generally there is no product revenue. The typical securities issued to those investors are in the form of preferred stock. The approaches during stage 3 are most commonly the income approach, using a DCF, or the market approach, using the guideline public company or guideline precedent transaction methods. However, as the profits for the enterprise may still be years in the future, these methods are most often times not exclusively relied upon; as multiple rounds of institutional financing may have occurred during these stages, the Backsolve Method may provide a reliable indication of value.
Stage 4 – Enterprise has met additional key development milestones (for example, first customer orders or first revenue shipments) and has some product revenue, but it is still operating at a loss. Typically, mezzanine rounds of financing occur during this stage. Also, it is frequently in this stage that discussions would start with investment banks for an initial public offering (IPO). Both the income and market approaches are typically appropriate for stage 4. The reliability of a financial forecast would tend to be higher in stage 4 than in stage 3, because there is more information available on which to base the forecast, and, therefore, the discount rate for a DCF method under the Income Approach would tend to be lower in stage 4 than in stage 3, reflecting the lower degree of risk. Additionally, given the company is now more established, there may be identifiable public companies that can be considered comparable in relation to operations but adjusted for relative size, expected growth, and profitability.
Stage 5 – Enterprise has product revenue and has recently achieved breakthrough measures of financial success such as operating profitability or breakeven or positive cash flows. A liquidity event of some sort, such as an IPO or a sale of the enterprise, could occur in this stage. The typical securities issued are all common stock, with any outstanding preferred converting to common upon an IPO (and perhaps also upon other liquidity events). Income and market approaches would generally be appropriate as in stage 4, and the discount rate for a DCF method under the Income Approach would tend to be lower in stage 5 than in stage 4. Under a Market Approach, because the enterprise may be closer to a liquidity event in stage 5 than in stage 4, adjustments to the valuation based on comparisons with publicly traded startup enterprises would tend to be lower in stage 5.
Stage 6 – Enterprise has an established financial history of profitable operations or generation of positive cash flows. Some enterprises may remain private for a substantial period in this stage. An IPO could also occur during this stage. Both the income and market approaches would be appropriate for an enterprise in this stage. Because the enterprise has an established financial history, the reliability of forecasted results would tend to be higher than in an earlier stage, and, therefore, the discount rate for a DCF method under the Income Approach would tend to be lower than in an earlier stage.
Regardless of the stage of development, if a- recent arms-length transaction has occurred, the Backsolve Method may be used to determine the equity value of the Company. The Backsolve Method is an application of the OPM which allows for the allocation of a total equity value where the most reliable total equity value is based on observed subject company equity participating securities transactions. It is based on pricing from the Company’s latest transaction, waterfall allocation schedule and the Black Scholes option pricing formula. The Backsolve Method helps to calculate and validate the Fair Value of the granted options and securities on a post-deal basis.
The sum of the indicative values of all the participating securities provides a total value. These amounts are then translated, through contractual terms, to determine the Fair Value. In calculating the indicative value conclusion, the results of the redemption and liquidation scenarios are considered, and Option Pricing Model is used to calculate the Fair Value Conclusion. If the appraiser knows the capital structure to the extent that in the event of a liquidation the proceeds from such liquidation can be mapped to the capital structure, then a reliable total equity value can be estimated if one class of equity participating security has been exchanged in an arm’s-length transaction. In other words, we know the value of the recently purchased preferred stock. Knowing the preferences obtained in the transaction by the preferred shareholders and the prior preferred stock rounds, we can then estimate the value of the common stock which does not contain these preferences. This method has limitations, such as the need to estimate certain exit events and assumptions regarding the unchanging nature of dividends or the capital structure over the time period from the valuation date to the estimate exit date.
Types of Equity Issued:
As mentioned above, the type of equity issued will be closely tied to the company’s stage of enterprise development. During the earlier stages of enterprise development, preferred equity is most commonly issued to attract investors and account for the inherent risks associated with early-stage companies. As the company continues to develop and stabilize, equity issuance begins to move down the capital structure. The most common types of equity issued from early-stage companies, in order of typical preference, are as follows:
Convertible Notes: The most common types of debt issued to investors in early-stage companies are convertible notes. These securities are viewed as short-term debt instruments that will likely convert into equity in the issuing company. They are typically repaid in equity as opposed to the traditional interest + principal payments on standard debt. These securities may automatically convert into equity once a specific milestone has been reached, usually when the company is officially valued for later investments.
Preferred Stock: Preferred stock is typically issued during enterprise stages 1 through 4. These securities are a class of stock that possess special rights and privileges that make them more attractive in comparison to common stock. They are often more protected from dilution and have the ability to influence company decisions. Additionally, these securities take priority above common stock in the capital structure under a liquidation scenario. These securities are most often those associated with a recent arms-length transaction that are utilized in the Backsolve Method to determine common value.
Common Stock: Common stock is the most common form of company shares that are issued. These securities are typically issued when the company is in the later stages of enterprise development. These shares can be granted voting rights, which can be limited, and often heave lesser rights than preferred shareholder. Common stock is typically last in the capital stack.
Stock Options: Stock options are commonly used as a valuable equity compensation incentive for hiring and retaining top talent. When issued, these securities give the employee the right, but not obligation, to purchase company shares at the predetermined price (i.e. the strike price).These securities are often strategically issued to assist in saving compensation expense for the company.
The Option Pricing Model:
The Option Pricing Model is a popular and commonly used model to allocate equity value to securities in complex capital structures. Often times early-stage companies will have complex capital structures with preferred and common stock. Because of this, the analyst needs to complete a two-step process: value the entity’s equity value and allocate the value between the classes of stock considering all rights and preferences of each class.
The OPM helps to allocate this value bytreating each class of security as a call option on the total equity value of the company. To accomplish this, the OPM typically employs the Black-Scholes model to value the call options. The OPM method uses five main inputs to allocate equity to various equity-participating securities: FMV of an equity security, annual expected firm dividends, time to next round of financing or sale of the company, overall company volatility indication, and a risk-free rate.
The exercise prices of each “call option” are set equal to the breakpoints, above which different combinations of equity classes participate in the liquidation equity value of the company. The model consists of a series of closed form option models.
Each breakpoint’s option model output is then subtracted from the prior breakpoint’s option model output to isolate the amount of value available to the equity participating securities between those two total equity values. That value is then divided pro rata among the relevant equity participating securities. Lastly, for each equity participating security, each of its pro rata allocated values is summed together. Appropriate discount and premiums if applicable are then applied to conclude on a value for that class of equity participating security.
Conclusion:
Although the process of valuing an early-stage company may seem complicated at first, an understanding of the stage of enterprise development, capital structure, outstanding equity rights and preferences, and relationship with a trusted advisor will make the process simpler.
