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The Impact of Rights and Preferences on Late Stage Funding

No one will argue that a transaction in a company’s own stock is the best indication of value – provided, of course, that the transaction occurred among willing and able buyers and sellers, neither acting under compulsion and both having reasonable knowledge of relevant facts. In fact, it is typical for the valuation community to look at prior sales of company securities as an indication of value. These third party sales are often in the form of new capital raises.

Entrepreneurs often raise capital in multiple rounds of financing, and valuations tend to rise over subsequent rounds as a company progresses through stages of enterprise development (i.e. proof-of-concept, product development, customer orders, revenue, operating profitability, and positive cash flows). Each round of financing is priced independently and typically involves new investors. The price in each round is ideally set by the cash flow expectations of the company and return objectives of the investor. As long as the company is growing and achieving milestones, it is reasonable to expect that the stock price in the new round would be higher than in prior rounds. The value of the company can simply be determined by looking at a post-money value calculation ($ Amount of Capital Raised / % of Ownership Acquired = Post Money Value).

However, when valuing companies with “complex” capital structures (meaning companies with different classes of stock and multiple rounds of financing), looking at a straight post money calculation as an indication of value for the company does not take into account the rights and preferences that may have been negotiated on the preferred shares issued. If you were to apply a traditional post money calculation to determine the value of the company then the protective provisions and other economic rights of preferred shares would be assumed to have no value. As such, the valuation and the audit community have relied on the utilization of a Backsolve Option Pricing Model method (“Basksolve OPM”). The Backsolve OPM has evolved into a standardized and broadly accepted method to determining the equity value of companies with complex capital structures.

The Backsolve OPM method takes into account the rights and preferences of each class of stock, market interest rates, industry sector volatility data, and the appropriate time period to a liquidity event to calculate an implied indication of total equity value for the company. Under the Backsolve OPM, the appropriate market value of equity for the company is solved for where value allocated to the most recent capital raise equals the amount investors paid to purchase the shares.

The rights and preferences negotiated on preferred capital raises impact the implied equity value of the company. Often times, the more onerous the rights and preferences, the lower the implied equity value. When investors negotiate liquidation preferences that are senior to prior rounds or are one time, two times, three times, etc. the original issue price, those benefit the investor. It results in a lower implied equity value for the company, and it assumes that those rights and preferences had to be given in order to secure financing. In most cases when those more onerous preferences are negotiated, it is for good reason because the company may be struggling to hit operational milestones. Where the Backsolve OPM method can “break down”, however, is in late stage companies.

Late stage financing rounds are typical small (compared to the total amount of capital raised) and are meant to bridge the company to a desired liquidity event. In our experience in valuing portfolio companies for venture capital firms, we have seen where the application of the Backsolve OPM method results in an indication of value that is unsupported by the fundamentals of a late stage company. Ultimately, the venture capital investor is faced with a write down in its holdings because the senior rights and preferences of the “bridge” round crams down the value of the prior rounds of funding.

An example can help illustrate the impact of a senior financing round on a company’s valuation. A late-stage technology company closed a Series D preferred round of financing at two times the price of the prior round, reasonably indicating an increase in value. Management indicated that the company had been performing well and had been achieving operational milestones. The price of the new round and management outlook suggested that the company’s value should rise. Utilizing the Backsolve OPM method and the recent Series D preferred financing, however, would have resulted in the investor taking a write down in its holding value (which included prior series of preferred shares) because of the seniority of the Series D shares and their higher liquidation preference compared to the prior rounds of financing. In this example, the Backsolve OPM method understated the equity value of the company.

While the Backsolve OPM method is simple and remains the most preferred valuation method by the valuation and audit community, it doesn’t always reflect the fundamentals of the company and should be carefully considered. The stage of a business greatly influences the merit of any valuation approach whether that is a Backsolve OPM method or other more traditional approaches to value such as the market approach and the income approach. However, when raising capital, management would be well advised to better understand the impact of certain rights and preferences on the implied value of their company. Management’s ability to understand the nuances of their capitalization structure is just as important as understanding how revenue and profitability drive financial value.

When valuing interests in holding companies, appraisers typically incorporate the asset-based approach. The asset-based approach considers the value of the subject company’s assets and liabilities in order to arrive at the value of equity. The net asset value (“NAV”) method is one method under the asset-based approach where the appraiser determines the fair market value of each asset on the company’s balance sheet as well as any intangible assets that may not be listed. The resulting total fair market value of the company’s total asset base is reduced by the fair market value of its liabilities. The resulting value is considered to be the fair market value of the company’s total equity. Because an investor would need to force the sale of all assets in order to achieve this level of value, the NAV method is considered to be on a control (can force sale) marketable (can achieve the fair market value of the assets upon sale) level of value. This is in contrast to a liquidation value or “fire sale” value where all assets are liquidated as quickly as possible for whatever price might be achieved.

When valuing controlling interests, the NAV method is an insightful look at what it would take to recreate the owner’s position. If an investor could purchase all of the same assets, she may be able to replicate the subject business. However, it is challenging to apply the NAV method to minority interests. A minority interest holder cannot force the company to sell its assets. Further, even if the asset is sold, the minority interest holder cannot compel the company to distribute the proceeds from that sale to the shareholders. These hurdles prevent the minority interest holder from accessing any value that the underlying assets may represent.

In order to account for the risks of the minority interest holder, discounts for lack of control (DLOC) and discounts for lack of marketability (DLOM) are typically applied to the NAV derived under the asset-based approach. Using closed-end mutual funds (CEFs) and registered limited partnerships (RELPs), the appraiser can determine an appropriate DLOC. Various methods such as Restricted Stock Studies or a Mandelbaum factor analysis are then employed to estimate the DLOM.

The problem with the NAV method in minority interest valuations is that the DLOC and DLOM are not observable. An appraiser can make informed estimates of the discounts required to provide fair returns to shareholders; however, moving from the control, marketable indication to a non-marketable, minority indication requires the appraiser’s judgement.

Solution 1 – Market Approach

One way to address the problems with the DLOC is to consider the market approach. The Guideline Transaction method under the market approach considers the prices paid by investors to acquire interests in similar companies.

The Guideline Transaction method uses the same CEF and RELP information as utilized in the NAV method to calculate pricing multiples. The derived price-to-NAV multiples reflect the amount that investors paid to acquire minority interests in similar companies, relative to their NAVs. Using this pricing data, the appraiser can select an appropriate price-to-NAV multiple that applies to the subject interest. The resulting indication of value is on a marketable, minority basis.

While both the NAV method and Guideline Transaction method utilize the same CEF and RELP data, changing the presentation allows Quist to better defend the implied DLOC against the IRS for the simple reason that the Guideline Transaction method concludes on a marketable, minority basis and arguments that need to be made when utilizing the NAV method in regards to the degree in which minority interest holders have the ability or lack of ability to liquidate the underlying assets of the entity, to influence management, and to determine the timing and amount of distributions is moot.

Solution 2 – Income Approach

In order to bolster the conclusions of the asset-based and market approaches, Quist considers the benefits that the minority investor receives from holding the investment. The benefits of ownership are based on what an investor will receive and when they will receive it. Under the income approach, the discounted cash flow method (“DCF”) discounts a series of future income streams based on a multi-period forecast. The cash flows for holding companies are typically low and the timing of any dispositions is typically unknown. We can view various scenarios under the DCF method (perpetual, 5-year and 10-year holding periods, to name a few) to determine whether the investor will earn an appropriate internal rate of return. The indication of value resulting from the DCF analysis is based on the present value of the benefits received by the minority shareholder. Therefore, the resulting indication of value is on a marketable, minority basis.


After considering the three approaches to valuation – asset-based, market and income – Quist will consider the merits of the approaches and conclude on a weighted indication of value on a marketable, minority basis. However, further adjustment needs to be made for minority interests in private holding companies because the shares are not freely traded.

Applying and Defending the DLOM

Various methods for estimating the DLOM have been used. Typically, the appraiser looks at studies of observable discounts and makes qualitative and quantitative comparisons to the subject interest. Based on a number of factors, the appraiser uses judgement to select the appropriate DLOM.

What is often missing from the traditional DLOM analysis is a test of its applicability to the subject interest. A benefit of the DCF method is that it can be a tool for performing a test of the DLOM. Applying a DLOM reduces the price an investor would pay for the minority interest. Using this lower purchase price and the cash flows determined in the DCF analysis, we can calculate the internal rate of return (“IRR”) of the investment. Comparing the IRR before and after the application of the DLOM illustrates the increase in rate of return that the subject investor would receive on the non-marketable investment. This increase can be compared to other studies which further defend our clients from IRS challenges. With these alternative valuation methods, we, at Quist, are armed and ready to defend DLOC and DLOM discounts.

Quist is on the forefront of integrating these alternative valuation methods when valuing holding companies. The industry is at a tipping point and moving away from what is “traditional” and familiar to these alternative valuation methods that consider specific attributes such as distributions, leverage, historical performance and liquidation horizon. Since the asset-based approach does not quantify future benefits or income generating ability, it is important to consider these alternative valuation methods. Being able to quantify the DLOC and DLOM through the lens of what a hypothetical investor would require in additional return on investment for the risk being borne is a valuable tool in defending our clients from IRS challenges.