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.
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