The analysis of complex capital structures and equity compensation plans has become increasingly important to media, telecommunications, and emerging technology companies. Companies are required to follow the tax and accounting rules set forth in Internal Revenue Code Section 409A and Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 718, Stock Compensation (formerly FAS 123R).
The valuation of a company’s capital structure begins with determining the fair value of the business enterprise. The enterprise value can be determined by using the cost, market, or income approaches to valuation. Typically, the market or income approach is employed to determine the value of a business as a going concern. The enterprise value is adjusted for cash and cash equivalents and debt to determine the equity value available to shareholders. Stock valuations, by their nature, require special sensitivity to applicable rights and restrictions. These limitations may result in the consideration of certain adjustments for lack of control, liquidity and marketability, and voting rights.
Companies usually issue two types of stock: common and preferred. Where there are multiple classes of stock, the equity is allocated among the various classes of securities based upon the rights and preferences afforded by each type of security. Economic rights may include preferred dividends, liquidation preferences, mandatory redemption rights, conversion rights, participation rights, anti-dilution rights, and registration rights. Control rights can include voting rights, super-voting rights, veto rights, board participation, drag-along rights, and first refusal rights.
There are four equity value allocation methods that are commonly used. The methods include the probability-weighted expected return method (PWERM), the option-pricing method, the current-value method, and the hybrid method. Given that the allocation of equity value is complex and varies from company to company, none of the four methods are superior or capture every particular right or preference. For this reason, an experienced valuation professional should be consulted to deal with the unique challenges embedded within each of these equity value allocation methods.
A recent assignment illustrates the complexity of an equity compensation valuation. Bond & Pecaro was retained by a publicly-held digital media and e-commerce company to analyze the company’s preferred stock minority interest investment in a privately-held technology company for its FAS ASC 350 compliance activities. The assignment required a detailed analysis of the financial performance of a fast-growing private software-as-a-service (“SaaS”) company and modeling future financial forecasts to determine the current enterprise value of the business. Valuation of the minority interest investment required further examination of the liquidation and conversion preferences for numerous classes of securities, warrants, and options. The Black-Scholes option pricing model was selected to allocate the equity value to the various classes of preferred and common stock, as well as numerous warrants and common stock options. Finally, the analysis required an assessment of the preferred stock investment for its marketability characteristics.
FASB ASC Topic 718 requires that equity awards provided to employees reflect fair value. ASC 718 covers share-based payments to employees while ASC 505-50 deals with non-employees such as directors, consultants, contractors, and other service providers. The proper valuation of equity compensation is essential given the wide variety, complexity, and rapidly changing underlying economic elements of these plans. Plan valuations are critical since they form the basis of compensation to retain key employees and are an important component in cash management. It is critical that companies have confidence in the proper valuation of the equity compensation in order to meet the accounting and tax requirements for recording compensation expense.
Equity compensation plans may include stock options, stock appreciation rights (SARs), employee stock purchase plans, grants and warrants, restricted stock and restricted stock units, and phantom stock. Companies offer equity compensation plans to provide key employees an ownership stake in the business, to help focus employees on company specific goals, and to preserve cash.
Companies have a variety of equity compensation plans to offer both employees and non-employees for their services. Stock options, both non-qualified stock options (NSOs) and incentive stock options (ISOs), give employees the option to acquire a certain number of shares of a company at a fixed price over a finite time period. Key components of stock options include the underlying equity value of the business, exercise price, option period, and vesting schedule. Stock appreciation rights and phantom stock provide employees with a bonus in the form of cash or stock based upon the increase in the value of the underlying company or segment over a specific time period. Restricted stock plans give employees the right to acquire stock once certain restrictions are lifted. These restrictions may be based upon time, performance, or other goals set by company owners.
The valuation of complex capital structures and equity compensation plans has become more complex in recent years, particularly for private technology firms funded by angel investors, venture capital, or private equity. There are many variables that enter into the determination of the fair value of a company’s equity. Likewise, where there are multiple compensation plans or classes of stock involved, an experienced valuation professional will have the capability to evaluate the diverse set of rights and privileges that comprise such plans.
Bond & Pecaro’s stock and equity valuation reports provide clients with important information necessary to manage their financial decisions and equity compensation plans. Our experienced valuation professionals are able to carefully examine and articulate the competitive, market, operating, and financial characteristics affecting economic value. Please contact any of the principals at the firm with any questions or requests for additional information.