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409A Valuation Issues

Guideline Venture Funding Method

For early stage companies that have raised capital in the form of preferred equity or similar instruments the Guideline Venture Funding or "back-solve" method is often required to derive a proper value for common shares. The Guideline Venture Funding method involves estimating the value of the business by taking the price of the latest venture preferred equity investment, or similar funding, and calculating what liquidity event would be be required for that preferred equity series (or similar instrument) to receive its original investment amount, given certain assumptions about the exit event, the company's capital structure, and volatility. An option pricing model using the Black-Scholes formula is used to solve for the implied exit value (see example).

Equity Value Allocation

Since we wish to determine the fair market value of one share of common stock and an early stage company may have several series of preferred stock or other equity instruments a critical step is to determine how the equity value of the company would be allocate among the different equity instruments, given a certain value for 100% of the equity.

Several methods for allocating the equity value can be acceptable, but each method may have certain merits and problems, and there may be tradeoffs in selecting one method over another. The most commonly used methods are the Common Stock Equivalent Method, the Current Value Method, the Option Pricing Method, and the Probability-Weighted Expected Return Method.

Common Stock Equivalent Method: This method allocates the enterprise value assuming all equity classes are essentially common stock. Hence, all equity shares including preferred stock and common stock, regardless of their rights and preferences, are treated as if they are all equivalent. Consequently this method will often indicate a value for common stock that is too high and is seldom used.

Current Value Method: The current value method allocates the value of the various series of preferred stock or other instruments based on their liquidation preferences or conversion values, whichever would be greater, using a waterfall approach. It is based on the assumption that at the valuation date each preferred shareholder will exercise his or her conversion rights in an optimal manner to extract the greatest benefit. However, this method does not account for time value and is therefore primarily used for very early stage companies.

Contingent Value Method: The contingen value (or option pricing) method is a way of allocating the total equity value to each security in the capitalization table based on a Black-Scholes option formula analysis. We use options to account for the terms of each security, the time we intend to hold the investment and consider market inputs such as volatility. It is similar to using a waterfall to allocate value, however the contingent value method considers the time value for more junior rounds that may not receive a distribution if the entity were sold today. The contingent value method may be somewhat complex to implement and is sensitive to certain key assumptions, such as volatility. Furthermore, it assumes that the investment returns follow a lognormal distribution which may not be correct in the case of a private company.

Probability-Weighted Expected Return Method: Under a probability-weighted expected return method, the value of the common stock is estimated based upon an analysis of future values for the business assuming various future outcomes. The future outcomes modeled may include an Initial Public Offering (IPO), merger or sale, liquidation, or continued operation as a private business. Common share value is based upon the probability weighted present value of expected future investment returns, considering each of the possible future outcomes available to the business, as well as the rights of each share class. This method is very flexible but often complex to implement, requires significant input from company management and may be best suited to later stage companies that have some visibility regarding exit opportunities.

Valuation Discounts

As 409A valuations are concerned with the value of one share of common stock (or unit in the case of a limited liability company), that is a minority interest, discounts for lack of control and lack of marketability are typically applied relative to a 100% equity interest in the business being valued. For a discussion regarding such discounts see our section on Valuation of Minority Interests.

For further details regarding 409A valuations we recommend that you consult the AICPA Guide Valuation of Privately-Held Company Equity Securities Issued as Compensation.