PRINT THIS PAGE Determining company value based on capital raising is a tricky business22/08/2007. Source: IVCJ (Israel Venture Capital Journal). 
Dont be misled by common simple calculations of company value cautions BDO Ziv Haft Consulting & Management executives Udi Savithsky and Efrat Shust. In this IVCJ article, they explain how valuations are generally far more complex. Company X raised $YY million based on a $ZZ million value.
Headlines such as this frequently appear in the financial press. Seemingly, the information presented to the reader is plain and clear.
Capital raising took place, and investors have received a percentage of the company in return for a certain sum from which one can derive the value of the entire company. For example, if the company raised $10 million in return for stock representing 50 percent of shareholders equity, it means that the company's post-money value is $20 million and the premoney value was $10 million.
Valuing companies is not so simple
The typical high-tech company capital structure, particularly for young firms, allows company value to be derived from capital raised. However, determining company value based on capital raised involves complex methodologies, taking into account the stratified structure of company capital, features of the different classes of stock, company risk level and a forecast of future results.
The typical capital structure includes a number of share types: ordinary shares, which are usually held by the founders; and preferred shares, held by various investors, including venture capital funds. In most companies several types of preferred shares exist (Preferred A, Preferred B, etc.). The preferred shares endow their holders with several distinctive rights in two areas:
Control Management appointments, director appointments, decision vetoes, etc.
Capital Liquidation preference, conversion to ordinary shares, etc.
Capital raising often takes place through issuing the most senior existing share class or issuing a new type of share that has preference over existing shares, including existing preferred shares. Among other rights, these shares provide for their holders to receive a specified sum usually the original investment at a liquidation event prior to any other shareholder distribution. Therefore, even while ignoring other preferred rights that these shares might have, the liquidation preference causes these shares to have a higher value than other company shares.
Thus, determining company value by multiplying the price per share in the capital raising round by the total amount of company shares (or dividing the amount invested by the percentage of the company received by investors) is erroneous. The reason is that the set share value applies only to the preferred shares issued in the most recent capital raising, while the value of other shares with inferior rights is lower.
How low is the value of ordinary shares compared to preferred shares? For years, the venture capital, high-tech and appraiser convention was "an ordinary share equals 10 percent of the preferred share." This reflected the feeling that the preferred shares made it difficult for ordinary shareholders to receive compensation in cases of liquidation. For example, there are numerous cases in which there are four to five types of preferred shares, where the cumulative preference compensation may reach tens of millions of dollars.
Only when the company value exceeds this sum will the ordinary shareholders get to participate in the distribution of the reimbursement. The common analysis of the ordinary share value was a division of the present value of the company (based on discounted cash flow, on various rates or on other methods) among the different share classes, based on the liquidation preference.
In almost all cases where a company had not achieved maturity, the division of the present value led to the conclusion that all of the value would be allocated to the preferred shareholders, while ordinary shareholders would not receive any compensation or a negligible sum at best. This is how the concept of low ordinary share value had originated. Taking a conservative approach, the allocated value was 10 percent of the preferred share value based on the value of the most recent capital raising.
In 2004, new AICPA guidelines specified methodologies for valuation of different types of company shares:
Probability-Weighted Expected Return Method:
In this method the share price is evaluated based on analysis of future values of the company. The analysis takes into account a number of possible future scenarios regarding the company, each of which is assigned a certain probability. In each scenario, the monetary value is divided among the shareholders according to their liquidation preference. Afterwards the probabilityweighted value of the ordinary share is calculated and discounted by the risk-appropriate discount rate.
Option-Pricing Method:
According to this method, each share class is evaluated as if it were a call option on the company. The base asset of the "options" is the company value (unlike regular options, in which the base asset is the stock itself). The characteristics of the shares, including conversion rates and liquidation preferences of each class, determine the monetary value of each share class, and thus the value of the shares themselves. The rationale behind this method is that holding ordinary shares of a company has no value below a certain value of compensation in case of liquidation, and as the value increases above this sum, the value of ownership increases as well. This has similarities to the behavior of stock options, except in this case the option is on the value of the entire company.
Current-Value Method
The valuation under this method is based on allocating the present company value according to the rights and preferences of each share class. The use of this method is appropriate only in special cases where the company is on the verge of liquidation or in which the company is at such an early stage that no significant value is generated. The probability-weighted expected return method requires many assumptions regarding future scenarios (including the date and value of the exit in each scenario) and their probabilities.
In most cases it is quite difficult to calculate. Therefore, the option-pricing method is regarded as the preferred method of valuation. Through this method, it is possible to derive the value of each of the share types and, on this basis, to calculate the company value derived from the capital raising.
The option-pricing method: an example
Company X's capital structure consists of six million ordinary shares. The company raises $4 million and issues two million preferred A shares in return. In case of liquidation, the preferred shareholders will receive, prior to any other distribution, the invested sum in addition to annual interest of five percent. Any additional sum will be distributed pro-rata among all shareholders (both ordinary and preferred A).
Seemingly, the pre-money company value is $12 million and the post-money value is $16 million (representing the purchase of 25 percent of the company in return for $4 million). However, as aforesaid, this calculation ignores the differences between the various shares and overestimates company value.
The ordinary shares are considered as call options on the company value. Calculating the option value using the Black-Scholes model, we would plug in the following parameters: Assuming that the liquidation event will take place in five years, the expected term of the option is five years. Since compensation to the preferred shareholders will be $5 million ($4 million plus 25 percent interest), in order for ordinary shareholders to receive any compensation, the total payoff should be above $5 million. Therefore, the option's exercise price is set at $5 million. For the purposes of this example, we assume a risk-free interest rate of 5 percent and company volatility of 80 percent. The received amount should be multiplied by the percentage of ordinary shares, i.e. 75 percent.
Preferred A shares, on the other hand, consist of two financial instruments. The first is the preference right and the other is the equivalent of an ordinary share, since the preferred Ashares participate in the distribution after the payment of the preference. The value of these shares is known, since it is the invested amount per share at the capital raising.
The preference right could be calculated as the difference between the values of two company options, which have all the aforementioned features (expected term, risk-free interest rate and volatility), when the first option has an exercise price of zero (since these shareholders will receive a payoff before all the rest), from which we deduct the second option with an exercise price of $5 million (the sum from which the distribution will be pro-rata). The equal right for ordinary shares will be calculated as described above, but will also be multiplied by the holdings of the preferred A shareholders, i.e. 25 percent. The only missing parameter for calculating the value of the various options is the company value.
The value of both rights, which reflect the value of the preferred A shares, should be equal to the amount paid for these shares. Therefore, we get an equation in which there is a value for preferred A shares on the one hand, and on the other hand, the expression of this value appears as a function of the company value. From this equation we can derive the company value and consequently the value of the options and the different shares.
The capital raising-derived post-money company value, according to the above analysis, is $9.6 million about 60 percent of the "naive" $16 million value. The value of an ordinary share is $0.93, 30 percent of the value of a preferred A share.
This example well reflects the distance between figures received by simple calculations, slogans and gut feelings and between results calculated through economic models. As demonstrated, finding company and/or ordinary share value based on capital raising is a complex process, requiring an analysis of the company's capital structure and the use of models, including various financial instruments. It is important in determining company value or ordinary share value in decision-making relating to company holdings valuation, setting exercise prices for employee stock options and more. The economic analysis of the value is critical for understanding the economic meaning of the decision, as well as for passing review by the various authorities (SEC, IRS, etc.).
This article appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com
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