How do different equity classes impact the accuracy of a 409A valuation?

In a 409A valuation, once the valuation analyst derives the enterprise value, the next and final step is to allocate value among all the equity classes. This final step can be extremely simple if only one equity class exists. All one needs to do is divide the enterprise value by the number of outstanding common shares to find the share price.

However, in a startup, you may find multiple equity classes that have different voting rights, liquidation preferences, and other characteristics. In such cases, you cannot simply divide the value equally across all equity classes. Hence, if there are multiple equity classes in 409A valuations, the final step of 409A valuations, equity allocation, can become challenging.

You must choose the right value allocation technique method to allocate value to the different equity classes in 409A valuations. But before you do that, you must understand which different kinds of equity classes you may encounter in 409A valuations. Read on to know more!

Types of equity classes

The equity classes in 409A valuations can be classified into the following types.

Preference stock

Companies may offer preference stock to investors to lower their risk exposure and make the investment more appealing. Typically, a preference stockholder gets preference in the distribution of dividends and assets and does not possess any voting power.

If a company issues cumulative preference stocks, the preference stockholder will be entitled to dividends even when the company is making a loss. Until these dividends are paid out at a later date, the common stockholders will not receive any dividends.

Common stock

Common stockholders have the lowest priority in payouts. Before a company declares dividends to its common stockholders, it must pay its creditors and preference stockholders. Only then can common stockholders be paid.

Hence, in 409A valuations, once the enterprise value is calculated, it is first allocated to the preference stockholders based on the extent of their payout preference. Then, the remaining enterprise value is allocated to the common stockholders.

Stock-based compensation

In 409A valuations, we assume that the vesting requirements for stock-based compensations such as employee stock options, restricted stock units (RSUs), and phantom stocks have already been met and these compensations have been exercised.

So, the residual enterprise value after allocation to preference stockholders is allocated to common stockholders and stock-based compensation assuming that all compensation is vested and exercised.

How to allocate value to equity classes in 409A valuations?

In 409A valuations, you must use the income approach, asset-based approach, and market approach, in combination or independently, to estimate the fair market value (FMV) of the company. The Internal Revenue Code (IRC) defines the fair market value (FMV) of a company as the acceptable price in a market where all material facts about a company are known and understood.

Once you have estimated the FMV, you can proceed with the allocation of value to equity classes in 409A valuations. You can use one of the following methods for value allocation to equity classes in 409A valuations:

Current value method (CVM)

In this method, the estimated proceeds from an immediate sale or liquidation of the company are assumed to be the enterprise value. Then, the enterprise value is allocated to each equity class based on their liquidation preference or converted value, whichever provides a greater value allocation.

Since enterprise value is equal to the liquidation or sale value, this method is appropriate when liquidity events like acquisitions or dissolutions are imminent. In such a scenario, any future expectations become irrelevant and can be safely ignored from the valuation process.

This method can also be used by early-stage startups that have not made significant progress yet and have no reasonable basis for estimating their future prospects.

Example

CodeCrafters is a tech startup that expects an acquisition from a major IT corporation within the next year. At present, the acquisition offer puts the enterprise value at $50 million. Since the liquidity event is imminent, we can use the current value method (CVM).

CodeCrafters capital structure details:

So, as per CVM, the value allocation for the equity classes will be:

Option pricing method (OPM)

In the option pricing method (OPM), equity classes are treated as call options for the enterprise value. Instead of thinking of common stockholders and preference stockholders as independent parties, we must see them as two sides in a transaction. If common stockholders decide to sell or liquidate the company in the future, they must first pay the liquidation preference to the preference stockholders before they can receive the residual value.

We can define this relationship as two types of options in the following manner:

• Preference stockholders are seen as a group that can pay a strike price of $0 to receive their liquidity preference.
• Common stockholders must pay a strike price equal to the liquidity preference of preference stockholders to receive the remaining enterprise value.

The value of these call options is derived using models like the Black-Scholes model.

Since OPM incorporates uncertainty about future liquidation, it is an appropriate method for value allocation to equity classes in 409A valuations of companies where no liquidity events like mergers and acquisitions (M&As) or funding rounds are in sight.

Example

WealthWise is an American personal finance app with no imminent liquidity events. After an analysis, it is found that the enterprise value could be $40 million from a liquidity event in 3 years.

Typically, the risk-free interest rate is the benchmark interest which is currently 5%.[1] We also know that the liquidity preference for preference shareholders is $16 million, there are 100,000 preference stocks and 500,000 common stocks.

For this example, we will assume that the volatility is 35%.

Value allocation for preference stockholders:

Since the enterprise value is higher than the liquidation preference, all we need to do is discount the liquidation preference by the risk-free interest rate.

Preference stockholder value = $16 million / (1 + 5%)3
= $16 million / 1.157625
= $13.82 million

Value allocation for common stockholders:

Here, we need to apply the Black-Scholes model formula for call options which is:

• all option price = S × N(d1) – K × e-rt × N (d2)

Where,

• S = Underlying asset value
• K = Strike price
• r = Risk-free interest rate
• t = Time
• N = Normal distribution
• σ = Volatility
• d1 = ln(S/K) + (r+σ2/2) × t  / σ × √t
• d2 = d1 – σ × √t

The calculations will look something like this:

So, as per OPM, the value allocation for the equity classes will be:

Probability-weighted expected return method (PWERM)

In the probability-weighted expected return method (PWERM), the enterprise value is calculated as a weighted average of all possible future outcomes.

First, you need to estimate the enterprise value in any kind of liquidity event such as initial public offerings, funding rounds, acquisitions, and liquidations. You must also find the probability of each of these events.

You must multiply the enterprise value in each outcome with its weight, i.e. the probability, and then, allocate enterprise value as per the liquidity preferences or conversion values. You must also discount these values using the risk-free interest rate.

The value of each equity class will be determined by summing its discounted weighted values across all potential future outcomes.

PWERM is an appropriate method for companies with multiple potential outcomes and complex capital structures. Shareholders can benefit from the PWERM analysis since it provides a comprehensive view of the potential value of equity in all possible future outcomes.

Example

EcoThreads is an online marketplace for sustainable and ethically produced clothing. It expects the following liquidity events.

We know that the liquidation preference for preference stockholders is $20 million, there are 100,000 preference stocks and 800,000 common stocks. Also, let us set the discount rate as the US benchmark interest rate of 5%.

Based on this, we can make the following calculations.

Note: Initial value allocation to preference stock is the liquidation preference and for common stock it is the remainder of enterprise value.

So, as per PWERM, the value allocation for the equity classes will be:

Unlock your fair value with Eqvista’s 409A valuations!

Estimating a company’s value is just the beginning. To complete the process, that value must be allocated to equity classes in 409A valuations. However, multiple equity classes can make this final step challenging and compromise the accuracy of a 409A valuation.

Inaccurate 409A valuations leave you vulnerable in the case of Internal Revenue Service (IRS) audits. So, to ensure accuracy, you must use one of the three methods described in this article for value allocation to equity classes in 409A valuations.

Our findings can be summarized as:

If you require assistance with 409A valuations, consider reaching out to Eqvista. Our team of NACVA-certified valuation analysts has ensured tax compliance for over 15,000 companies through accurate 409A valuations.