From the category archives: Option-Pricing Method

Option-Pricing Method

Rules of Thumb

Is there a rule of thumb for valuing common stock relative to preferred?  If a new preferred round is priced at $1.00 per share, can we assume that the value of common is $0.10?  No.  By now, most managers of venture-backed companies understand that the old 10% rule is dead.  The AICPA Practice Aid (Valuation of Privately-Held-Company Equity Securities Issued as Compensation) states “The use of ‘rules of thumb’ is not (and never has been) an appropriate method for estimating the fair value of a company’s common stock.”  Nevertheless, many managers still want to get a sense of the common stock’s value before engaging a valuation specialist.  Once the draft appraisal is completed, managers often respond by saying it doesn’t “feel” right.  The guidance is the guidance, but that doesn’t prevent us from at least asking the question:  mathematically, is there a way we can reliably estimate the value of common r ...

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Changes in the Value of Common Stock

One reason it’s difficult to value common stock in a venture-backed company is that the value of common is more volatile than the value of equity.  A small swing in equity value, up or down, can trigger a much bigger change in the value of common.  If we’re valuing equity based on market multiples, which change every day, the value of common is likely to bounce around. The volatility is the result of financial leverage, the same phenomenon which contributes to higher earnings and losses in companies financed with debt.  Unless equity value is high enough to trigger conversion of preferred, the preferred liquidation preference is like debt.  Equity value may increase by a small amount, but if it all flows to common with none to preferred, the effect on common value can be dramatic.  To illustrate, assume a venture-backed company is capitalized with 1,000,000 preferred shares and 500,000 common shares.  The preferred liquidation preference is $10 per share, so the pr ...

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