The valuation of financial instruments in firms with complex capital structures poses challenges for appraisers, as these instruments demand a nuanced approach. In an era where financial markets exhibit increasing dynamism and companies employ sophisticated financing arrangements, understanding the valuation intricacies becomes paramount. This article aims to provide a breakdown of the methods, challenges, and considerations involved in valuing financial instruments within firms characterized by a complex capital structure.

B. Understanding Complex Capital Structure

Complex capital structures involve multiple classes of equity and are typically observed in start-ups and early-stage companies. This is because they are funded via multiple investment rounds and each round of investment involves a different set of investors with differential rights and preferences. Multiple classes of equity include but are not limited to common stock, convertible preference shares, employee stock options etc.

The straightforward subtraction of the liquidation preference from total equity value may not suffice, especially when a sale isn’t imminent. The valuation challenge lies in accurately attributing value to different equity classes, considering potential future scenarios.

The first step involves valuation of equity to arrive at the total value to be ‘allocated’ or distributed amongst the different classes of equity. Once the final equity value conclusion is derived from either one, or a combination of the methods mentioned above, the process of allocation begins, which is the systematic distribution of the proceeds of equity (liquidation proceeds) to the various classes of financial instruments, in accordance with their economic rights.

C. Commonly Used Allocation Methods

1. Probability-Weighted Expected Return Method (PWERM):

A company can have several liquidation events and scenarios upon which the amount allocated to each security might differ. The PWERM hinges on analyzing such potential scenarios, like an IPO, acquisition, or wind up of the business. Each scenario’s value is estimated, considering specific equity class rights and features, that are often defined in the shareholder agreements. Probabilities, often influenced by management input, are assigned to these scenarios. The resulting valuation for each equity class is the sum of probability-weighted expected returns. While the PWERM is a forward-looking method, and thus may capture potential upside, it heavily relies on assumptions and is most effective when there are multiple distinct scenarios to be considered.

Illustration:

Let us assume that a company has three liquidation scenarios, with the following probabilities assigned to them:

The company has two classes of shares- 10,000 equity shares, and 5,000 Series A, optionally convertible Preference shares. The preference shares were issued at SGD 1,000 each and have a conversion ratio of 1:1.

The Company will likely undergo an IPO after six months, and the shares will be compulsorily converted into equity shares, per the shareholders’ agreement. If the IPO does not take place, the company will likely redeem the preference shares at their issue price. In this case we have assumed that all the 3 events would likely take place at the end of six months period.

In the event of a dissolution/winding up, the preferred shareholders are likely to receive 800 pounds per share.

In this case, the PWERM would yield a value of 877 pounds, as calculated below (assuming a discount rate of 15%).

2. Option Pricing Model (OPM):

The OPM treats each financial instruments as a call option on the total equity value, with exercise prices derived from liquidation preferences for each instrument, at which equity holders will make decisions regarding their participation in the value. If the preferred liquidation value exceeds the funds for distribution, then common stock is worthless. It is best to use the OPM when future outcomes are difficult to predict, and forecasts are unreliable. The OPM is most appropriate to use when future outcomes are not possible to predict, and the liquidity event is not imminent. However, it assumes a single liquidity event.

3. Current Value Method (CVM):

CVM assumes immediate liquidation/conversion of each of the classes of equity at the “current value” of the business, on an ‘as-is’ basis. The allocation process of CVM is relatively simpler than its counterparts. Value is allocated to various classes of equity based on higher of their liquidation preference and conversion values. It is pertinent to note that the equity value that is allocated to the classes of equity is the equity value as at the current date and not some future date like in OPM and PWERM, and often used when there is an imminent liquidation event or when the company is still at an early stage of development and does not have reason to estimate value beyond preferred shares.

4. Hybrid Method:

The Hybrid Method combines elements of PWERM and OPM. It estimates probability-weighted values across multiple scenarios and uses the OPM to allocate values within each scenario. Applicable when an exit scenario is uncertain, the Hybrid method weighs equity values under different scenarios based on their respective probabilities. This method is suitable for situations where an anticipated exit scenario may or may not materialize.

D. Selection of the appropriate valuation method

Choosing the right valuation method for a complex capital structure involves careful consideration. As mentioned above, each method can be employed within a specific set of factors. The American Institute of Certified Public Accountants (AICPA) recommends assessing several other criteria, like:

• Correspondence with Going-Concern Status: The method should reflect stockholders’ expectations regarding timing, cash flows, and uncertainties, aligning with the business’s going-concern status.
• Approximability: Results should be replicable by another valuation professional using the same data and assumptions, minimizing reliance on proprietary methods or data.
• Alignment: The complexity of the method should match the business’s development stage, ensuring accuracy and relevance.

E. Difficulties in valuation of financial instruments 

• Frequent Capital Structure Changes: Firms with complex capital structures often undergo changes, such as capital raises or debt restructuring, requiring continuous adjustments in valuation models. For example, start-ups often engage in several rounds of funding, wherein the rights and preferences of the new instruments may require a revisit of the order of liquidation.
• New instruments: The dynamic nature of the financial markets breeds innovation, but the introduction of new types of instruments and securities add another layer of complexity for the appraiser, as they enter unchartered territory for valuation and must exercise extra vigilance.
• Dependency on Assumptions: Complex securities often involve a high degree of reliance on assumptions regarding future market conditions, cash flows, or other factors, introducing uncertainty into the valuation process.
• Model Complexity: Valuing complex securities requires sophisticated financial models that may be more prone to errors, especially when the underlying assumptions or parameters are not well understood.

 Valuing firms with complex capital structures demands a strategic and adaptive approach. No one-size-fits-all method exists, and the selected methodology should align with the company’s unique characteristics and development stage. Engaging an independent valuation firm can prove invaluable, offering expertise in compliance, regulatory matters, and strategic events, such as acquisitions, financing rounds, or IPOs.