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JAN 16, 2017

Not all Investors are same - Instruments and Preferences impact Value

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Not all investors are same - the stronger the preferences assigned to any investor, the lower would be the value of the common equity shareholders. For Example: if the company has raised INR 10 cr. funds by issuing Cumulative Convertible Preference shares (Preferred Shares) which gives investor 20% shareholding in the company on fully dilutive basis, it would not be reasonable to assume that all the shares of the Company have equal rights and hence the equity value of the company is INR 50 cr. In practice, the value of such preferred share is significantly higher than each of the remaining common equity shares. The resultant impact is that the equity value of the company would be significantly lower say at INR 40 cr. and so would be the value per common equity share.

Investors often invest in equity shares of a company with certain preferences as compared to the common equity shareholders. These preferences can be of various types like preference in distribution of company’s value over other investors in the event of a sale or liquidation of the company besides participation in Profits of the Company. These preferences assigned to investors can offer them significant downside protection in the event company value declines and also let them share in the upside of the Company.

This articles aims at understanding practical application of an Internationally used valuation approach “Backsolve” to derive the implied overall equity value of company and resultant value of different series of equity instruments from an Investment transaction involving company’s own shares, typically – Preferred Shares as such shares indicates the equity value consistent with the return expectations of the independent investors at arm’s length price considering their special preferences at that time.

Option Pricing Model (OPM) is generally most commonly applied in Backsolve approach as it captures speculative nature of common stock.

    Two types of Breakpoints are created in Backsolve OPM model:

    • Breakpoints in accordance to liquidation preference
    • Breakpoints as per payoff (Allocation of incremental value of the Company)

The OPM values each class of securities at each breakpoint as a call option on the value of the company. In this method, each share class only has value if the funds available for distribution to shareholders exceed the value of the liquidation preferences at the time of a liquidity event for each of the prior share classes in a company's capital structure. Incremental call option at each breakpoint is then allocated based on total no of outstanding participative securities.

Example:

Company X receives 2 Mn$ against issue of 100,000 Series A Convertible Preferred Shares of 10$ each in the latest funding round. The Preferred shares have 1:1 conversion ratio and 100% Liquidation Preference (i.e. 10$ each share). There are 400,000 common equity shares of 10$ each in the company.

Going by the latest round of funding, it may seem that the value of company has reached 10 Mn$ (i.e. 2 Mn$/20%). Backsolve model can be applied here to verify if it’s correct and if not

Creation of Breakpoints (Exercise Points) for applying Black Scholes Model:

  1. First based on the liquidation preferences
  2. Breakpoint 1 will be at 0

    Breakpoint 2 will be the liquidation preference amount i.e. 2Mn$ in our case

  3. Then based on the Payoff preferences
  4. Preferred shareholders will convert to common equity shares once the company value is above 10Mn$. There will be sharing between Preferred and Common Shareholders based on the no of shares)

    Breakpoint 3 will accordingly be 10Mn$

The OPM then values each class of securities as a call option on the value of the company.

The OPM relies on following inputs:

  • the total equity value of the enterprise^
  • expected time to exit
  • expected risk-free interest rate as of the valuation date
  • expected volatility derived from similar publicly traded companies
  • expected dividend yield

Applying Black Scholes model with company value of 10Mn$ and above 3 exercise points, Backsolve model results in Preferred Stock value of 2.39Mn$ which is not equal to the amount invested (i.e. 2Mn$), implying that the value of company should be less than 10Mn$.

The Value of company is to be computed (by trial and error) such that the value of recent preferred stock investment equals the price paid for such investment as per the backsolve method. In the instant case, the value of company shall be 7.33 Mn$ at which the value of Preferred stock shall come at 2Mn$ through Backsolve model.

Result Comparison between Normal and Backsolve Valuation Methodology:

Particulars Not Adjusting Equity Value for Preferences Adjusting and allocating Equity Value for Preferences
Basis Simple Capitalization of Recent Investment (in Mn$) As per Backsolve model (in Mn$)
Equity Value of Company 10 7.33
Equity Value of Common Shares 7.60 5.32
Value per Common Share 19.01 13.32

The above concludes that Common Shares cannot command the same Value as Preferred Shares and rather gets a significantly lower valuation per share. It should be noted that this also impacts the overall equity value of the company and simple extrapolation of recent round of Preferred Investment would result in over valuation of the company and is not recommended.

To conclude, the analysis of complex capital structure has thus become increasingly important when a company has been financed by several rounds of funding with different classes of preferred and equity securities as well as warrants, options, employee stock options etc. with each having its own rights and preferences. The value of each of such instruments could be different and requires application of complex valuation techniques, judgment and expertise of Business Valuers.

AUTHORED BY

Mr. Chander Sawhney

Partner & Head-Valuation and Biz Modelling

FCA, ACS