(Part 2) Equity Allocation Using Option Pricing Method for Privately Held Companies

With Simple Capital Structure

Today's post is by Upasak Shah, the Co-Founder and Director of Knowcraft Analytics Private Ltd. Mr. Shah has an extensive background with 15+ years’ experience in providing business valuation, and transaction and advisory services for companies spanning technology, life sciences, and various other industries. Mr. Shah has performed valuations for hundreds of privately held businesses and a handful of publicly traded companies for a variety of purposes, including mergers and acquisitions, gift and estate taxes, 409(A) compliance, purchase price allocations, mark to market for large portfolios, embedded derivatives, intellectual property, complex securities, and goodwill impairment.

Mr. Shah has spoken at several webinars for Indian valuation professionals on topics related to business valuation and opportunities for valuation professionals in India, among others. Prior to co-founding Knowcraft, he worked at EXL, where he pioneered transaction advisory and complex security valuation services. He has proven expertise in valuing derivatives and embedded securities using complex models, such as Lattice or Monte Carlo simulations.

In 2019, Mr. Shah was nominated for 40 Under 40 by NACVA. Mr. Shah holds a Master of Commerce degree from Gujarat University, India and a Master of Science degree in Finance from the ICFAI University, India. He is the Director of Academy of Certified Valuators and AnalystsTM (ACVA) — NACVA’s India Chapter focused on nurturing business valuation talent in India.

Mr. Shah can be reached at [email protected]

Executive Summary

In Part I of the post, we discussed the capital structures in high-growth and early-stage private companies and the application of an option pricing model (“OPM”) to allocate value through a simple capital structure. We also briefly compared the OPM and a current value method (“CVM”).

In Part II, we will extend the example to include preferred conversion rights and compare outcomes with and without these rights. In addition, we will discuss another method for the equity allocation, the probability weighted expected returns method (“PWERM”).

Types of Preference Shares

Preference or preferred shares are a type of hybrid stock because they blend debt and equity elements. In the preference stack, preferred shares rank below debt and above common shares. Generally, preference shareholders have the right to receive dividends announced by the company before issuing dividends to common stock. The holders may also be entitled to the distribution of assets before common stockholders, in a payout scenario. For example, if the company is liquidating, the preference shareholders are entitled to claim the remaining assets left before the common stockholders receive their share.

There are different types of preference shares, described below:

1. Cumulative Preference Share – This type of preference share gives the holder the right to receive cumulative dividend payments. These dividend payments will be counted as arrears in years when the company is not earning profits and will be paid on a cumulative basis when the business generates profits.

2. Non-Cumulative Preference Share – This type of preference share does not collect dividends in the form of arrears. In the case of these types of shares, the dividend payout takes place when the company generates profits in a particular year.

3. Participating Preference Share – This type of preference share enables the holder to participate in the exit proceeds at the time of the company’s liquidation, after the liquidation preference has been paid to other shareholders. This scenario was modelled in the example presented in the Part I article.

4. Non-Participating Preference Share – This type of preference share does not entitle the shareholders to the excess exit proceeds after the payment of liquidation preference.

5. Convertible and Non-Convertible Preference Shares – Convertible preference share enables the holder to convert their shares into a fixed number of common stock. While not all companies will allow preferred shares to be converted (these are called Non-Convertible Preference Shares), this practice enables the holder to take advantage of a degree of capital appreciation in the company in the long run. Before converting the preferred stock, holders must check the conversion ratio to determine if it is profitable. Convertible preferred stockholders generally convert their shares if the common stock price trades above the conversion price.

Features of Preference Shares

In addition to some of the features discussed in the section above, preference shares also provide:

• Fixed Dividend Payouts – Preference shares allow shareholders to receive dividend payouts when other stockholders may receive dividends later or may not be receiving dividends. These shareholders have a priority compared to common and other stockholders.

• No Voting Rights – Preference shares do not have the right to vote like common shares.

• Downside Protection – Preference shares offer greater downside protection because they issue fixed dividends, are higher in the capital structure relative to common stock and often have a “liquidation preference” (means in a liquidation scenario, the preference share will guarantee a certain level of return before any common equity is paid out).

• More Upside than Debt – Preference shares are often convertible into common equity at a certain point (after a certain amount of time, above a certain dollar amount, or in the event of a company sale). This gives the investor the downside protection of debt and the upside of equity.

• Perpetual – Unlike a maturity date in debt, preference shares are typically perpetual.

OPM Analysis Including Convertible Non-Participating Preferred Shares

Consider the same early-stage technology company from Part I of the article, with the following capitalisation table:

All investors have liquidation preference (“LP”) equivalent to their investment amount. Series B is senior to all other equity holders, and Series A is senior to common. The preferred investment does not accrue any dividend and in the event of a liquidation, dissolution or winding up of the company, preferred shareholders cannot participate in the remaining proceeds after receiving its liquidation preference. Assume that the equity value of this early-stage technology company is £125 million.

Compared to the example in Part I, the preferred shares are non-participating and convertible. As a result, once the value of common shares exceeds the value of preferred shares, the preferred shareholders will convert to common shares (beneficial scenario). The conversion terms are outlined in the company’s articles of incorporation or association. In the current example, we will assume the conversion ratio of preferred to common is 1:1.

The key steps to perform an OPM analysis for this company are outlined below:

Step 1: Calculation of Breakpoints:

Step 2: Tranche Value:

Step 3: Allocation of Value:

Step 4: Distribution of Tranche Value:

Step 5: Determination of Per Share Value:

Comparison of Outcomes: With and Without Participating Preference Shares

A non-participating convertible preference share provides an investor with either the liquidation preference or the converted value of the common shares. Whereas with a participating preference share, the investor receives both: the liquidation preference and participation in surplus assets distributed to common shares. As such, all else being equal,

a participating preference share is going to result in a higher value than the non-participating convertible preferred, because of the participation in surplus assets in addition to the liquidation preference. Note the comparison of outcomes for both types of preference shares:

Probability-Weighted Expected Returns Method

Another method of equity allocation, the PWERM, is a financial decision-making approach that takes into account the probabilities of different future scenarios when estimating the expected returns of various potential exits. Share value is concluded based on the probability-weighted present value of the expected future outcomes, as well as the rights and preferences of each share class.

The PWERM is a preferred approach for capturing potentially dramatic increases or decreases in value that may result from future events that are not log-normally distributed, as under the OPM.

Key Assumptions and Steps in the Application of the PWERM

The PWERM requires the following inputs and assumptions to model the exit scenarios:

• Identify Possible Exits: This represents the company management’s expected mode of exits in the future, like initial public offering (“IPO”), merger and acquisition (“M&A”), liquidation, etc.;

• Identify Exit Dates: Depending on the company’s development milestones, the exit dates represent the potential dates in the future when the company may plan to exit;

• Estimate Exit Values: This represents predicting potential future values of the company at the time of the exit date;

• Assign Probabilities to Exit Scenarios: Assess the likelihood for each exit scenario occurring and assign probabilities to each. Consider factors such as market conditions, industry dynamics, regulatory environment, and any specific risks or uncertainties associated with each scenario; and

• Determination of Discount Rates: For each of the securities (common and preference shares) and the overall company, the allocated future values as of the exit dates under different exit scenarios are discounted to present values using appropriate discount rates.

Key Steps to Perform a PWERM Analysis

Consider the same company from prior example, and assume the same capitalisation table. The preference shares are non-convertible, fully participating and accrue no dividend.

Step 1: Exit Scenario Modelling: Identify the company’s targeted modes of exit based on discussions with management. Furthermore, in addition to the successful exit scenarios, certain failure scenarios are also modelled based on failure to achieve the development milestones and insufficient cash runway.

Step 2: Identifying Exit Dates: Based on the product development timeline, and the various value inflexion points, the company’s management expects certain future inflexion points where the company may target going public or get acquired. As such, the time to exit is modelled accordingly.

In our example, assume that at the end of two years, the following outcomes are possible for the company:

1. If the company successfully completes its product launch:

a. Upon receiving a suitable M&A offer, it may consider exiting via an M&A transaction – M&A Early;

b. If not, it may prepare to go public and may exit via an IPO at the end of three years – IPO Early; or

2. It may continue to gain market traction and exit at a later date; or

3. The company fails in the beta product launch and liquidates at the end of three years.

At the end of the fourth year, the following outcomes are possible for the company:

1.If the company successfully gains market traction, then:

a. Upon receiving a suitable M&A offer, it may consider exiting via an M&A transaction – M&A Late; or

b.If not, then the company may plan for an IPO exit at the end of the fifth year – IPO Late; or

2.The company fails to gain sufficient market traction and due to insufficient funds to continue operations, liquidates at the end of five years.

Step 3: Exit Values: For each exit scenario, estimate the potential exit value. This may involve using various valuation methods, such as discounted cash flow, comparable company analysis, precedent transactions, or other relevant valuation techniques. Consider factors such as market conditions, industry trends, and company-specific factors.

Step 4: Allocation of Exit Value: Based on the rights and preferences of the different share classes in the company’s capitalisation structure, the estimated exit values are then allocated among the shareholders to calculate the future allocated values.

Step 5: Present Value: The future values are then discounted to present value using appropriate discount rates. Typically, a weighted-average cost of capital is used to discount the future exit values to calculate the present value of the company / securities.

Step 6: Probability-Weighted Value Calculation: The estimated present values under each of the exit scenarios are then probability-weighted to calculate the probability-weighted values allocated to each share classes and the overall company.