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Industry Update: IRS publishes an internal document that reveals the agency’s most current thinking on the valuation of S Corps

The IRS S corp Job Aid says in the introductory section:

[A]bsent a compelling showing that unrelated parties dealing at arm’s-length would reduce the projected cash flows by a hypothetical entity level tax, no entity level tax should be applied in determining the cash flows of an electing S corporation. In the same vein, the personal income taxes paid by the holder of an interest in an electing S Corporation are not relevant in determining the fair market value of that interest. Click to read Job Aid

The valuation community agrees that, in reality, investors consider both implicit and explicit taxes when making investment decisions. Practitioners may differ on how these taxes should be quantified; however, empirical evidence supports that all taxes are integral to understanding the fair market value of an interest.

A “Complex Security” can refer to a number of different financial securities including: 1) preferred stock; 2) convertible debt; 3) options; and 4) warrants. What makes one security more complex over the other? Simply put, it is the number of unknown variables or conditions that exist that drive the behavior of that security and ultimately its value.

Let’s look at an example of a “complex security” that most people are very familiar with – equity options. Equity options are commonly granted to employees by companies as a form of incentive. An option gives the holder the right to purchase or sell a stated number of shares of stock at a fixed price (also known as: exercise or strike price) within a predetermined period. The holder of the option, however, is not obligated to exercise the option[1].

The value of a stock option can be broken down into two components, intrinsic value and time value. Intrinsic value is the difference between the value of the stock and the exercise price. For example, if the share price is $90 and the exercise price of the option is $100, the intrinsic value is zero. Conversely, if the share price is $100 and the exercise price of the option is $90, the intrinsic value is $10. In general, as the value of the underlying stock increases, the value of the call option also increases. For privately-held companies that issue equity options the primary unknown variable is the price of the underlying stock.

The Black-Scholes model is the most widely used and best known theoretical option model for valuing options. The primary inputs of the Black-Scholes model are 1) stock price; 2) exercise price; 3) risk-free rate; 4) volatility; and 5) time to expiration. However, the Black-Scholes model has a number of limitations including:

  1. It is more appropriate for options with expiration dates that are relatively short;
  2. It assumes the short term rate is known and constant through time;
  3. The distribution of possible stock prices at the end of any infinite interval is lognormal;
  4. It assumes that the stock pays no dividends;
  5. It assumes the option can be exercised only at maturity; and
  6. It assumes no commissions or other transaction costs are incurred to buy or sell the stock or the option.

The Black-Scholes may not be appropriate to use for complex securities that have a fairly long time until expiration or for complex securities that have various triggering events (i.e. unpredictable conditions that will drive their behavior). A lattice model may be a more appropriate model to use when greater flexibility is required to predict exercise behavior and various market and performance conditions. Whereas the Black-Scholes model is a ‘closed form’ method that calculates the price of an option based on a formula of certain parameters, the lattice method is an ‘opened form’ method that requires the prediction of certain behaviors and parameters with distinct probabilities at certain points in the future.

Let’s take a look at an example of when a security becomes more complex to value and how a lattice model can better accommodate the flexibility required to value the security. We recently worked with a client to determine the value of a number of convertible debt securities issued by the company. Convertible debt securities are hybrid instruments since they exhibit characteristics of both debt and equity securities. What made these securities vastly more complex to value were the various events around when and how the convertible debt would convert (“Triggering Events”) and their corresponding payout structures. The convertible debt securities could be 1) held to maturity; 2) convert into an existing round of preferred financing or into a new round of preferred financing; or 3) receive two times the principal amount of the note if there was a change in control of the company.

In order to value the convertible debt securities, we had to determine:

  1. Under what conditions would the debt securities convert into existing preferred stock and when;
  2. Under what conditions would the company raise new capital and when;
  3. Under what conditions would there be a change of control and when; and
  4. What was the probability of default.

The value of the debt securities was different under each scenario and each scenario was dependent on several uncertain variables including timing and conversion ratios. The probability of each scenario was also dependent upon several internal and external factors outside the control of the company.

We utilized a binomial model to value the straight bond, a call option price lattice for the conversion option, and calculated the present value of any future payments of principal and interest in the case of a change in management or a company acquisition. Once each scenario was modeled, we probability weighted each scenario based on discussions with management, in order to determine the overall value of the security.

The lattice model is a decision tree model that allows for an infinite number of possible outcomes over time. In the illustration below, S is the value of the security and q is the probability of an upward movement to Su and 1-q is the probability of downward movement to Sd more complex and integrated model is required.

lattice model

Each node represents the value of the security and considers the probabilities of various triggering events and incorporates the value of the security of such an event occurs. Lattice modeling is a powerful analytic tool and when set up correctly can provide more accurate results. However, despite their many uses, lattice models remain a neglected tool in the appraisal process, primarily because they are complex to administer. When determining if a lattice model is appropriate to use, be sure that you are working with a valuation firm that has experience in valuing complex securities and knows how to set up a lattice model properly.

[1] There are two types of options: call options and put options. Call options provide the holder the right to buy a security. Put options provide the holder the right to sell a security

For an operating company, the income approach often provides the best indication of value to rely upon, because it reflects the cash flow expectations specific to the company. The income approach, specifically a discounted cash flow analysis (“DCF”), captures the value of a company’s future expectancy by discounting a company’s projected operating cash flows by a discount rate to yield a price that investors would be willing to pay for the indicated cash flow stream. As such, management’s projections are a key factor in determining the integrity and veracity of the indication of value resulting from the income approach.

The valuation community relies on the income approach as a primary method in determining the value of a company because, in most cases, publicly traded companies are too big with more diversified operations and guideline merger and acquisition transaction details are often limited. Projections and the underlying assumptions contained therein are discussed in the management interview. The management interview is an important step in the valuation process, as it is an opportunity for the management team to explain and justify the projections to the appraiser.  Management should be prepared to answer the following questions about their projections:

  1. What is the company’s current order backlog and how does it compare to prior years? What does it say about the current near term outlook?
  2. Are there any pending sales or project proposals outstanding that have not yet been awarded to the Company, but which could have a major impact on its results if awarded?
  3. How were the company’s projections prepared and with input from whom?

When developing projections, management should consider the following factors as a beginning point in developing company forecasts:


  1. Percentage growth by year
  2. Unit volume growth by year by product line
  3. Changes in unit prices by year by product line.
  4. Large or unusual factors contributing to future revenues.
  5. Likelihood of achieving forecast.
  6. Breakdown of anticipated growth between growth of market in total and Company’s growth in market share.

Gross Profit:

  1. Gross profit margin percentage trends by year overall and by product.
  2. Comparison to past actual performance.

Operating Expenses:

  1. Which line items represent fixed and/or semi-fixed costs.
  2. Which line items represent variable costs.

Tax Rate Changes

Capital Expenditures (Capex):

  1. Maintenance capex vs. Growth capex.
  2. Method of funding expenditures (internally or externally).
  3. How far (revenues) Company can go with current physical capacity?  Amount of excess capacity?

There are many common pitfalls in management projections:

  1. Projected revenue growth and profit margins exceed the Company’s historical performance or margins far exceed those achievable by the comparable peer group (aka: the industry, the marketplace);
  2. Closely-held businesses include expenses unrelated to the operations of the company (i.e. business owners personal expenses and salaries paid to family members who are not active in the business);
  3. Projected operating expenses and capital outlays don’t reflect levels to support the ongoing operations of the Company (i.e. business owners underpay themselves, computer equipment and software has not been updated, manufacturing equipment is dated and fully depreciated).
  4. Management projects depreciation expense outpaces expected capital maintenance requirements, or put more simply management is projecting its fixed asset base will deteriorate without additional capital spent to maintain or update the assets; and
  5. Projected net working capital requirements are significantly below that of industry peers.

When faced with projections that are out of line with past performance, Quist can make the following adjustments. First, we can reflect the risk of the Company achieving the projections provided by management by applying either a higher discount rate (if projections are “aggressive” relative to past performance) or lower discount rate (if projections are “conservative” relative to past performance) on the future projected cash flow streams. Second, we may run multiple scenarios (low-case, mid-case, and high case) and weight the resulting indications of value based on an assessment of the primary assumptions driving each scenario. Quist’s ability to run sensitivity analysis around a multitude of factors (i.e. revenue growth, margin, profit growth, etc.) helps us to understand where the primary risks are around management execution.

Good financial projections are a key piece to performing the income approach and arriving at a supportable and believable valuation conclusion. When creating projections, it is important for management to understand the underlying assumptions contained within each section of the company’s forecast. In addition, it is important that management clearly articulate how they arrived at their projected figures and how they plan to achieve the forecast, especially in regards to how the company has performed historically. A good understanding of this information will allow a management team to confidently explain how the company will address each assumption and make it a reality.

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.