Portfolio companies of private equity and venture capital funds often provide equity-based compensation to employees. Certain forms of equity compensation, such as stock options, profits interests, or appreciation rights, are directly tied to changes in equity value. Option-based methods are used to value these types of equity compensation to comply with tax, financial reporting, and transaction requirements.
This article provides an overview of a special option-based valuation method, referred to as an OPM (Option Pricing Method) Backsolve. It’s based on pricing from the company’s latest transaction (such as an acquisition or the latest round of financing), a waterfall allocation schedule, and the Black Scholes option pricing formula. This method is generally preferred when a company has a complex capital structure with multiple classes of equity, such as preferred, common, convertibles, warrants, profits interests, or options. The OPM Backsolve is professionally recognized as a best practice and recommended in the new AICPA guidelines for valuation of equity compensation in privately owned companies. It is frequently used in venture capital, private equity, and other privately owned companies for the valuation of equity compensation to comply with tax requirements of IRC 409A and in financial reporting for ASC 718
Option-based valuation methods
Option-based valuation methods are used in most situations when equity compensation has an “if, then” conditional economic feature, where a threshold must be reached before the employee shares in value. A common example of this is a stock option, where the employee can purchase stock at a specific price and have a gain if it’s redeemed when the stock is at a higher price. Profits interests, stock appreciation rights, or restricted shares with certain performance conditions are other examples of equity compensation with similar conditional economic features.
Option-based valuation methods arrive at a value that differs from what the employee would receive if a liquidity event occurred and proceeds were paid out on the valuation date. This is because an option-based valuation method considers the potential for future changes in value. The potential to achieve increases in value over time is a fundamental component in the award of many forms of equity-based compensation and an important part of its value to the company and the employee.
OPM Backsolve method overview
The OPM Backsolve is a special application of an option-based valuation method. It’s based on the principal that an economic relationship exists between multiple classes of equity securities in a company with a complex capital structure. That economic relationship is based on the connection these securities share with a common factor — the total equity value of the company. Although each type of equity security is connected with this common factor, each can individually have distinct features. Differences can include rights such as liquidation preferences, required returns, conversion options, exercise prices, or other items. These rights will define the order, values, and amounts at which each class of security is entitled to a share of equity value. This allocation is referred to as a waterfall. Differences in the levels and participation in the various stages of the waterfall result in differences in value for each class of security. This may even be the case when all equity-related securities might be convertible into common shares.
In the OPM Backsolve method, the economic rights, relationships, and participation levels in the waterfall of the securities are used with Black Scholes to create an option-based equation for the equity capital structure of the company. This equation provides the ability, when the value of one class of equity security is known, to calculate a value for all other equity-related securities, including equity compensation. The value reflected in the pricing of the latest transaction provides the benchmark data used to help solve that equation.
The first step in using the OPM Backsolve Method is to determine value thresholds in the waterfall for the company. These are derived from corporate agreements, the capitalization table, and rights of the various equity-related securities. The equity interests that would share in value for each threshold in the waterfall are also identified, along with their corresponding participation amounts at these levels.
Next, an option-based valuation equation is constructed using Black Scholes for the capital structure of the company. This incorporates the relationship between total equity value, waterfall thresholds, rights, and various participation levels of all the equity-related securities. Estimates are also developed regarding the expected equity risk (volatility) in the business and potential time period to an exit (or other liquidity event). This equation will determine the value associated with achieving each threshold, and amounts expected to be allocated to the various equity classes at all stages in the waterfall. This equation also incorporates the probability that the value thresholds may or may not be achieved in a potential exit.
Then, pricing data for the latest transaction is assembled. In private equity and venture capital, this often involves an investment in preferred shares, although it could be any equity security in the capital structure. Generally, the latest transaction data should not be more than a year old and be of an adequate size and arm’s-length. In addition, no changes that could materially affect value should have occurred in the company since the latest transaction. In some instances, adjustments to the latest transaction pricing or an alternative basis for this component may be considered.
In the final step, a backsolve technique is used to determine the common factor, the total equity value, which connects all the different securities. A backsolve is simply a way to identify the input needed for an equation or the process that produces a specific result, such as in reverse engineering. For this valuation method it means adjusting the total equity in the Black Scholes-based equation for the capital structure of the company until it results in a value for the selected security equal to its price in the latest transaction. At that point, the equation has been solved, and provides a value for all equity securities in the company, including equity compensation units.
Additional adjustments to the value of equity compensation units may then be considered for any discounts or premiums relating to control, marketability, or other factors. Most equity compensation units in private companies are non-controlling (minority), non-marketable interests. For portfolio companies of venture capital and private equity funds, any discounts or premiums will reflect the expectation for a potential exit/liquidity event and the nature of the equity security in the latest transaction.
The OPM Backsolve method captures the option features and waterfall relationship inherent in the equity ownership of many venture capital and private equity portfolio companies. This method is particularly well suited to companies with multiple classes of equity ownership. A primary advantage of this method is it establishes a value for equity compensation based on the support of the latest round of financing or transaction. This is an important factor in situations where other valuation approaches and methods may not be as effective.
A primary advantage of this method is it establishes a value for equity compensation based on the support of the latest round of financing or transaction.
Because of these features, this method provides a very useful tool to value equity compensation in portfolio companies of venture capital and private equity funds. Although not specifically discussed here, the option-based equation created for the OPM Backsolve method can also be used to value equity compensation when the total equity value has been determined other ways, such as from a discounted cash flow analysis or a market multiple method.
If you have questions, want further information, or need assistance with this method, feel free to give me a call.