On April 21, 2004, the American Institute of Certified Public Accountants (AICPA) released the Practice Aid titled Valuation of Private-Held-Company Equity Securities Issued as Compensation (Relevant to 409A). The Practice Aid describes three value allocation methods and the advantages and disadvantages of each method. The methods are:

1. Current value method.
2. Probability-weighted expected return method; and
3. Option-pricing method

The Practice Aid simply suggests that the method used should take into account the stage of the company’s development and the applicability of the particular method.

Although the Practice Aid is not an accounting standard, or formally approved by the SEC, it became ordinary practice and recent experience in a limited number of IPO filings, suggest that SEC staff is taking the recommendations of the Practice Aid into account in their review of registration statements.

These methods were also recommended for valuating private-held-company equity securities by the US IRS in the new Section 409A of the Internal Revenue Code. 

The Current-Value Method

The current-value method of allocation is based on first determining enterprise value using one or more of the three valuation approaches (market, income, or asset-based), then allocating that value to the various series of Preferred share based on their liquidation preferences or conversion values, whichever would be greater. The current-value method involves a two-step process, which distinguishes it from the other two methods described below that combine valuation and allocation into a single step. It is easy to understand and relatively easy to apply, thus making it a method frequently encountered in practice.

The fundamental assumption of this method is that the manner in which each class of Preferred shareholders will strike its rights and achieve its return is determined based on the enterprise value as of the valuation date and not at some future date. Accordingly, depending upon the enterprise value and the nature and amount of the various liquidation preferences, Preferred shareholders will participate in enterprise value allocation either as Preferred shareholders or, if conversion would provide them with better economic results, as ordinary shareholders. Convertible Preferred share, that is “out of the money” as of the valuation date is assigned a value that takes into consideration its liquidation preference. Convertible Preferred share that is “in the money” is treated as if it had converted to Ordinary share. Ordinary Shares are assigned a value equal to their pro rata share of the residual amount (if any) that remains after consideration of the liquidation preference of out-of-the-money Preferred share.

The principal advantage of this method is that it is easy to implement and does not require the use of complex or proprietary tools. The method assumes that the value of the convertible Preferred share is represented by the most favorable claim the Preferred shareholders have on the enterprise value as of the valuation date. However, this method often produces results that are highly sensitive to changes in the underlying assumptions. Another limitation of the method is that it is not forward-looking. That is, absent an imminent liquidity event, the method fails to consider the possibility that the value of the enterprise will increase or decrease between the valuation date and the date at which ordinary shareholders will receive their return on investment, if any.

Because the current-value method focuses on the present and is not forward-looking, its usefulness is limited primarily to two types of circumstances. The first occurs when a liquidity event in the form of an acquisition or dissolution of the enterprise is imminent, and expectations about the future of the enterprise as a going concern are virtually irrelevant. The second occurs when an enterprise is at such an early stage of its development that (a) no material progress has been made on the enterprise’s business plan, (b) no significant ordinary equity value has been created in the business above the liquidation preference on the Preferred Shares, and (c) there is no reasonable basis for estimating the amount and timing of any such ordinary equity value above the liquidation preference that might be created in the future. Since we do not question the going concern of the Company after the last funding round and it outgrow the above-mentioned stage of development, we do not consider this method appropriate for valuing Bio Sight.

The Probability-Weighted Expected Return Method

Under a probability-weighted expected return method, the value of the Ordinary share is estimated based upon an analysis of future values for the enterprise assuming various future outcomes. Share value is based upon the probability-weighted present value of expected future investment returns, considering each of the possible future outcomes available to the enterprise, as well as the rights of each share class. Although the future outcomes considered in any given valuation model will vary based upon the enterprise’s facts and circumstances, ordinary future outcomes modeled might include an IPO, merger or sale, dissolution, or continued operation as a viable private enterprise.

The primary virtue of this method is its conceptual merit, in that it explicitly considers the various terms of the shareholder agreements, including various rights of each share class, at the date in the future that those rights will either be executed or abandoned. This method involves a forward-looking analysis of the possible future outcomes available to the enterprise, the estimation of ranges of future and present value under each outcome, and the application of a probability factor to each outcome as of the valuation date.

However, this method requires a number of assumptions about potential future outcomes. Estimates of the probabilities of occurrence of different events, the dates at which the events will occur, and the values of the enterprise under and at the date of each event may be difficult to support objectively.

The Option-Pricing Method

The OPM treats Ordinary share and Preferred share as call options on the enterprise’s value, with strike prices based on the liquidation preference of the Preferred share. Under this method, the Ordinary share has value only if the funds available for distribution to shareholders exceed the value of the liquidation preference at the time of a liquidity event (for example, merger or sale), assuming the enterprise has funds

available to make a liquidation preference meaningful and collectible by the shareholders. The Ordinary share is modeled as a call option that gives its owner the right but not the obligation to buy the underlying enterprise value at a predetermined or strike price. In the model, the strike price is based on a comparison with the enterprise value rather than, as in the case of a “regular” call option, a comparison with a per-share share price. Thus, Ordinary share is considered to be a call option with a claim on the enterprise at a strike price equal to the remaining value immediately after the Preferred share is liquidated. The OPM has ordinarily used the Black-Scholes model to price the call option.

The OPM considers the various terms of the shareholder agreements, including the level of seniority among the securities, dividend policy, conversion ratios, and cash allocations, upon liquidation of the enterprise. In addition, the method implicitly considers the effect of the liquidation preference as of the future liquidation date, not as of the valuation date.