Valuing investments in private companies requires a robust understanding of the capital stack and the associated impact of liquidation preferences, conversion rights, and exit probabilities. A recurring debate in fund valuations concerns whether to apply the Option Pricing Model (OPM) or assume a Common Stock Equivalent (CSE) based on fully diluted shares when allocating company equity. This whitepaper explores the key considerations surrounding these allocation approaches, the circumstances under which each is appropriate, and the expectations of auditors in the private equity and venture capital ecosystem.
Capital Stack Considerations and Valuation Methods
A company’s capital stack consists of different classes of equity, each with its own rights and privileges. When valuing investments, fund managers must determine whether to allocate value across the stack using an OPM or assume a fully diluted allocation using the CSE, effectively ignoring preferential liquidation structures.
- Common Stock Equivalent and Exit Assumptions
Some investors advocate for valuing all equity on a fully diluted basis, particularly when they believe there is a high probability of an imminent exit (e.g., IPO, acquisition). The rationale behind this approach is that at an exit, liquidation preferences become irrelevant because all preferred shares convert to common equity at a higher valuation. In these scenarios, marking investments at the latest round price on a fully diluted basis may be reasonable. However, this assumption is highly dependent on the probability and timing of the exit, which is often uncertain in early-stage companies. - Option Pricing Model and Waterfall Analysis
In the absence of a clear and imminent exit, most valuation practitioners apply an OPM to allocate value across different share classes. The OPM accounts for the preferential rights of preferred stockholders, recognizing that if the company does not exit at a sufficiently high valuation, preferred shareholders will opt for their liquidation preference rather than convert to common shares. This approach provides a structured way to distribute value in accordance with contractual waterfall provisions, offering a more theoretically sound basis when exit timing is unclear.
Auditor Expectations and Market Precedents
Auditors generally prefer valuation methods that align with established industry norms and regulatory guidance. Several key factors influence their expectations:
- Precedent and Consistency: If an OPM has been consistently applied in previous valuations, deviating from it without strong justification may raise concerns about selective valuation adjustments.
- Regulatory and Industry Guidance: The AICPA Private Equity and Venture Capital Guide acknowledges that the OPM is widely accepted for valuing complex capital structures. While it notes that OPM may not be ideal for distinguishing between senior and junior preferred shares, this does not typically apply in cases where all preferred shares are pari passu.
- Practical Considerations: OPMs are used extensively by major valuation firms and audit practices, including within large funds, to ensure defensible and consistent valuation methodologies.
Addressing Client Perspectives
While some investors argue that applying a fully diluted CSE approach provides a more transparent valuation and is more aligned with how deal markers value shares, auditors and valuation professionals often push back for the following reasons:
- Exit Probability and Timing: The assumption that all shares will convert to common is only valid if an exit is imminent. In early-stage companies, the path to exit is highly uncertain, making an OPM allocation more appropriate.
- Share Class Rights and Liquidation Preferences: Preferred shares often retain significant downside protection. Ignoring these rights in valuation may overstate the fund’s unrealized gains.
- Regulatory Alignment and Industry Norms: Given the scrutiny of fund valuations by auditors and regulators, adherence to well-accepted methodologies like OPM mitigates risks of valuation disputes.
While a fully diluted CSE approach may be suitable in select scenarios where an exit is highly probable, or outcomes are more clearly bimodal, the OPM remains the industry standard for allocating value for fund investments in early-stage companies. Given the inherent uncertainty of private market exits, maintaining a structured approach to allocating value through OPM ensures consistency, defensibility, and alignment with auditor expectations. Fund managers should carefully consider these factors when determining the most appropriate methodology for their portfolios. Houlihan Capital stands ready to assist funds in navigating these complexities, ensuring accurate and compliant valuations that withstand auditor scrutiny.
Houlihan Capital’s Expertise in Valuation Services
At Houlihan Capital, we specialize in providing independent valuation services tailored to private equity and venture capital funds. Our team of experts works closely with clients to determine the most appropriate valuation methodologies based on the unique characteristics of each investment. Whether applying an OPM to allocate value through the capital stack or assessing fully diluted valuation assumptions, we ensure that our analyses align with industry best practices and audit expectations. Our extensive experience with complex capital structures and our deep understanding of auditor preferences make us a trusted partner for fund managers seeking robust and defensible valuations.
For questions or inquiries regarding valuation assistance, please contact:
info@houlihancapital.com
