By Craig Jacobson and David Kaye
Special to the Legal
The valuation of early-stage companies can pose unique challenges because of a lack of historic earnings or operating cash flow. However, when there has been a contemporaneous arm’s-length transaction such as a recent financing round, one can estimate the value of the company using a valuation method known as the backsolve method. This market-based valuation method has gained prominence in the valuation community. This is evident with the release of the American Institute of Certified Public Accountants’ 2013 guide, Valuation of Privately-Held Company Equity Securities Issued as Compensation, in which this method is discussed extensively.
The backsolve method considers the capital structure and the liquidation claims of the various securities issued by the subject company. The valuation analyst will often work closely with legal counsel to accurately interpret the rights of the various securities. Usually, with early-stage companies, the securities being valued (e.g., common stock) have junior rights compared to the securities sold in the most recent financing round (such as a senior series of preferred stock).
The senior claim of the preferred stock creates an “option-like” payoff structure for the common stock (i.e., the future enterprise value needs to exceed the preferred claim in order for the common to realize any value at all). As such, the backsolve method utilizes option pricing models such as the Black-Scholes model.
The backsolve method first estimates the enterprise value of the subject company based on the price of a recent arm’s-length transaction. The enterprise value is then allocated among the different ownership classes. In performing the backsolve method, the valuation analyst will apply a series of concurrent option pricing models to consider several “break points.” For example, initially, only the most senior securities will participate. The first break point is at the future liquidation value where the preference of the most senior securities is satisfied and the incremental value determined applying option pricing models is attributed solely to the holders of these securities. This “waterfall” procedure is repeated until the incremental value attributable to the securities sold in the most recent round equals the price paid by the investor.
The model considers the probability of a range of future values that may be realized at a liquidity event, and therefore reflects the possibility that a security class that might not have value upon an immediate liquidity event still might have value based on the possibility of an increase in value.
As with any valuation method, the backsolve method requires the use of several assumptions, the most subjective of which are (1) the term to an expected liquidity event and (2) assumed volatility. The expected time to a liquidity event should reflect the expectations as of the valuation date of investors in the company.
The backsolve method can be very helpful in estimating value in the presence of an arm’s-length transaction in company ownership. Sometimes the hardest question is: How does one determine whether a transaction is truly arm’s-length?
Craig A. Jacobson is a principal in Citrin Cooperman’s valuation and forensic services group. He helps clients resolve issues regarding the buying or selling of a company, intellectual property valuations and damages/lost profits analysis, among other issues. He can be reached at 212-697-1000 or [email protected].
David M. Kaye works in Citrin Cooperman’s valuation and forensic services group. He provides specialist valuation and consulting services for transaction, litigation support, financial reporting and tax compliance purposes. He can be reached at 212-697-1000 or [email protected].
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