PE/VC Fund Valuations and 409A Common Stock Valuation
October 30, 2016
In a valuation shop, a lot of the work is done for private equity and venture capital firms, as well as private companies who want to have their common stock valued. PE and VC companies like to have their total holdings in their portfolio companies valued, while other private companies are looking to value their common stock for accounting or employee compensation purposes.
Many PE and VC’s hold substantial equity in private companies, meaning these shares cannot be easily found like the shares of a public company can. Therefore, PE and VC firms hire companies in the Big 4 to have their investment values checked by a third party, usually as part of a Ch.1 audit review.
In these stock and option valuation engagements, the total value of the enterprise is first calculated, then these values are allocated to the various equity tranches that a company has (e.g. series seed, preferred series A, B, C, options and warrants, etc.). Financial analysts in a valuation company use complex financial models in order to map out the flow of value from the total enterprise value to the individual securities using option pricing models (OPM). Option pricing models take into account factors like seniority, liquidity preferences, participating preferred terms, and option strike prices to come up with per share prices for the securities being valued. Depending on the last financing round, variations of the OPM – either an OPM “back-solve” to the last transaction date, or an OPM roll-forward, or both, can be applied.
In some cases, a PWERM or probability expected weighted return model is used. This model is relatively straightforward and matches certain enterprise values with certain outcomes – usually a base case, an upside case, and a downside case.
In valuing these securities, it is important to understand discounts that are applied under certain terms – DLOM and DLOC. DLOM refers to discount for lack of marketability, which is typically applied to common stock. Common stock are less senior in the capital structure so they lose out to Preferred stock when getting paid out. DLOC refers to discount for lack of control. This is typically applied when a PE or VC does not hold majority stake in one of its portfolio companies or investments.