Volatility and value: Equity compensation
Stock options, restricted stock, profits interests, and other forms of equity-based compensation and share based payments in venture capital, private equity, and other privately owned companies may use a volatility factor to determine value. A volatility factor helps estimate the potential for future increases in value, an important objective in many equity compensation plans.
The value of equity based compensation in a private company is used for financial reporting, tax, and transactions. The selection of an appropriate volatility factor is needed to arrive at an accurate value. This discussion provides an overview of volatility and how it is used to value equity compensation in a privately owned company.
What is volatility?
Volatility, as it relates to equity compensation, measures the changes in financial returns for those equity interests over time. It shows how much, on average, the range of returns can fluctuate. A volatility factor for an equity interest is usually expressed as an annual percentage, representing the percent variation from the average. Statistically, it is the annualized standard deviation of the returns.
The return on a unit of equity compensation generally results from changes in value over a period of time, such as from the date the units are granted to when they are cashed in. Additional returns can come from dividends or distributions. Volatility for equity compensation commonly relates to changes in value of the equity interest (equity returns), and may also incorporate additional returns from dividends or distributions (total returns).
For equity compensation, a volatility factor is used to estimate potential changes in future value. It also provides a way to assess the riskiness of the units awarded. For equity interests in privately owned companies, risk and return are generally presumed to be related. Lower risk is associated with a lower expected return, and higher risk corresponds to a higher expected return. Accordingly, a lower volatility factor means less potential fluctuation in return and a higher volatility factor means a greater variability.
A lower volatility factor means less potential fluctuation in return and a higher volatility factor means a greater variability.
With equity compensation, a higher volatility factor will generally lead to a higher value of the units and a lower volatility factor results in a lower value (all else being equal). This is because a higher volatility factor, when compared to a lower one, provides a larger potential range of returns over time, resulting in a greater possibility to achieve higher value.
There are three basic types of volatility that pertain to equity compensation. The first, and often most common, is referred to as an “equity volatility” and it measures changes in the total equity capital of the company. The second is an “asset volatility,” and it measures changes in value for the total business enterprise, essentially its total assets. Finally, there is a “class volatility” which measures the changes in a specific type or class of equity interest, such as common or preferred shares.
The value of equity compensation is normally determined using these categories. The selection of the appropriate type will depend on factors including the capital structure of the company and features of the equity compensation. For example, in a company with a simple capital structure of common shares and employee stock options, an equity volatility might be used. When a company has convertible debt, an asset volatility may be applicable. And if the business has multiple categories of equity related interests such as preferred, common, warrants, and options, a class volatility may be more appropriate.
What creates volatility?
Volatility exists because equity value and the corresponding returns for equity compensation can fluctuate. A number of factors can cause the value for equity compensation in a private company to vary. These include changes in business performance, market conditions, risk, industry trends, debt levels, or capital structure.
Changes that affect volatility in private companies generally fall into two categories: those that impact the overall business value (often referred to as enterprise value) and those that have an effect on the value of individual equity interests in the capital structure (generally referred to as value per unit or class).
For equity compensation, changes in business enterprise value will usually lead to changes in value per unit. In fact, increasing the value of the overall business is often a primary objective in an equity compensation plan. The value of equity compensation units can also vary without changes in business enterprise value. This can occur as the result of changes including ownership/capital structure, debt, working capital, or the issuance of equity related securities.
A volatility factor measures how these changes impact equity values, and the corresponding returns, over time. The time period relating to equity compensation is generally from when the units are granted (awarded) until they are expected to be vested or cashed in.
Valuation methods that use volatility
There are a number of professionally recognized valuation methods for equity compensation in a private company that use a volatility factor. These methods include the Black Scholes equation, binomial (or lattice), OPM (Option Pricing Method) Backsolve, and Monte Carlo simulations. The use of volatility in these methods is briefly described below.
The Black Scholes equation is perhaps one of the oldest and most widely recognized methods. It is commonly used to value stock options. A volatility factor is a required input in this equation and is used to help determine the value corresponding to if, and by how much, share prices might exceed an exercise (strike) price in the future. The binomial method is another technique that may be used to value equity compensation. It can provide greater flexibility and the ability to consider various scenarios, conditions, or requirements than is possible with the Black Scholes equation.
The binomial method uses one or more volatility factor(s) and can also incorporate various time periods, probabilities, and contingencies. With this method, a volatility factor helps establish how an equity value might change between multiple points in time or in connection with specific events in the future.
The OPM Backsolve approach also requires a volatility factor. It’s often used when a private company has multiple classes of equity related securities, such as preferred and common shares or convertible securities. This method is often used in venture capital or private equity companies when there’s been a recent round of financing and that transaction is used as a benchmark to value the company. With this method, a volatility factor is used to estimate how the total equity value of the company could increase over time, the possibility future values (exit prices) could be reached, and how an option based value would be allocated to various equity related interests (waterfall) based on rights and preferences.
In another example, a Monte Carlo simulation is a method where a volatility factor is used to value equity compensation. This method is often selected when the equity compensation award is tied to achieving a certain return for an equity interest. In a Monte Carlos simulation, a volatility factor is used with other inputs in a mathematical equation to estimate a very large number of possible future equity values, and establish the probability that particular levels may be reached. The resulting range of potential outcomes is then used as a basis to value the corresponding equity compensation.
Finally, a volatility factor can be used to help estimate marketability discounts that might be applied to equity compensation. There are a variety of approaches based on put options used to estimate a discount for lack of marketability, including ones referred to as the Chaffe, Finnerty, investment, and others. These techniques incorporate a volatility factor to compute the price of a put option, which is then used to estimate the cost of a hypothetical source of liquidity.
Volatility in a privately owned company
As described above, a volatility factor is used to estimate future fluctuations in value. Clearly, the actual future changes for an equity related interest cannot always be identified. Results will come from events that have not yet taken place or cannot be completely predicted. Generally, to estimate an “expected” future volatility, a representative historical volatility is used as a basis to start. Adjustments are then considered to arrive at an expected future volatility factor.
A challenge in using this approach for a private company is there is usually an insufficient base of historical information from which to make a reasonable volatility calculation. This is not because the private company did not have any changes in value in the past. It reflects that measurements of value needed to calculate returns may not have occurred with enough frequency or support to provide reasonable data. In contrast, with a public company, shares trade daily and the corresponding historical market prices and returns can be readily determined. For a private company, such historical trading data rarely exists.
One professionally recognized and commonly used approach to address this issue is to use the volatility of equity interests from comparable publicly traded companies. These statistics then serve as a benchmark, subject to possible adjustment, that can be used as a basis for a private company.
With this approach, an “index” of publicly traded companies is created. Companies are selected for the index based on similarities in industry, market, customer base, and products or services. Other considerations include size, location, stage of development, and nature of operations. The public companies identified for an index are not necessarily intended to be an exact match for a private company. They are chosen to provide a reasonable, representative basis to estimate equity returns and volatilities for the type of business, financial markets, and industry.
Historical data for publicly traded stock prices is readily available through a variety of sources including Google, Yahoo, or company websites. This information can be used to determine the returns (percent change) needed to calculate volatility. The length of the historical period is generally selected to approximate the expected term for the particular type of equity compensation. Selecting an appropriate period may also consider market and business conditions or other factors.
Using this information, volatilities for each public company in the index are calculated. This will often produce a range of results that can be evaluated. Adjustments may be considered for differences between the private and public companies including stage of development, size, capital structure, and other factors. Additional adjustments may be required to arrive at asset or class volatilities, as further described in the following section.
Asset, equity, and class volatility factors
The historical stock prices of publicly traded companies used in an index are generally analyzed based on total common equity (market capitalization). This produces the equity type of volatility factor discussed above. When an asset or class volatility factor is needed, the equity volatility factor is often used as a starting point and adjusted to calculate another type of volatility factor.
In a company with a material amount of debt, an equity volatility will be higher than an asset volatility. For a company with preferred shares, the volatility of common shares will be higher than the preferred interests and the total equity of the company.
Differences among these types of volatility factors arise because the volatility of a particular interest can be influenced by its position in the capital structure. The principal cause of these differences is the existence of any preferences in the capital structure, resulting in senior and junior (or subordinate) rights to receive value. Volatility is a measure of changes in returns. The leverage created by debt or other preferences affects the volatility between levels in the capital structure and creates greater fluctuation in returns for the subordinate interests.
In a company with a material amount of debt, an equity volatility will be higher than an asset volatility.
One way to conceptualize how leverage influences volatility is to use the analogy of a see-saw at a playground: how much one side of the see-saw moves depends on the weight, position, and speed of the people using it. The ups and downs (volatility) for riders on each side of the see-saw may not always be equal. Similarly, when there is leverage or other preferences in the capital structure, changes in values and returns may not be proportionate across the various equity interests.
There are a variety of approaches that may be considered to adjust for the differences between asset, equity, and class volatility including ones referred to as the Merton, Hamada, CAPM, and other methods.
Volatility is an important factor in the valuation of many forms of equity compensation in privately owned companies. It helps identify the possibility for increases in value, potential returns, and level of risk. A number of valuation methods use a volatility factor. Understanding, selecting, and using an appropriate volatility factor is needed to accurately determine the value of equity compensation in a privately owned company.