The McLean Group: New Guidance on When to Use a Recent Round of Financing to Estimate Fair Value

Consider Three Types of Private Preferred Stock Transactions, Each with Varying Degrees of Relevance to an Indication of Fair Value: Simple, Strategic, and Tranched Preferred Financing

Last year, the AICPA issued guidance on evaluating private transactions with regards to their relevance in estimating the Fair Value of other securities within an enterprise via the back-solve method. The McLean Valuation Services Group  recaps that guidance and explains what it should mean in practice. Appraisers need to carefully follow specific criteria and they need to exercise reasonable judgment.

On August 10, 2012, the American Institute of CPAs (AICPA) task force released its working draft of the Accounting Valuation Guide.  In Chapter Eight of this release, titled “Inferring Value from Transactions in a Private Company’s Securities,” the AICPA provided guidance for evaluating private transactions with regards to their relevance in estimating the Fair Value of other securities within an enterprise via the backsolve method.  As background, the back-solve method uses the terms of a private transaction and a company’s capital structure to calculate the implied Fair Value of a company and its other securities.

In accordance with the guidance provided by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 350—goodwill and other, companies should test their goodwill and indefinite-lived intangible assets for impairment at least annually.  In 2011, the FASB issued new guidance allowing goodwill to be tested based on a qualitative assessment.  The intent of the FASB’s recently-issued guidance was to simplify and reduce costs associated with performing annual goodwill impairment tests.

The taskforce identified three types of private preferred stock transactions that may be completed, each with varying degrees of relevance as an indication of Fair Value: simple, strategic and tranched preferred financing.

Ideally, a simple preferred stock financing transaction is conducted at arm’s length, includes new investors, and involves a company that is not in distress. A simple transaction may also reflect Fair Value if it involves pre-existing investors so long as the company is not in distress and negotiations remain robust. Typically, up or down financing rounds—as opposed to flat financing rounds—are indicative of thorough due diligence and consequently representative of Fair Value.  However, when a company is in distress, the price of a new round may not reflect a going concern or may reflect some degree of a lack of marketability. To remedy lack-of-marketability issues, the transaction price might be adjusted to reflect a slight premium for the recent round.

As the name implies, a strategic preferred stock transaction involves a strategic relationship in which the investor and/or the company will benefit from the relationship in a way that does not necessarily directly benefit the other party. Consequently, the transaction price may not reflect a price that a hypothetical market participant would pay and, thus, is not indicative of Fair Value.

In such cases, creating a model to value the equity using other methods and then reconciling the model’s values to the transaction price might ensure that the price paid falls within a range of reasonableness despite the strategic benefits realized by the investor/company. If the transaction price is at market despite strategic benefits to either party, the back-solve method may be appropriate without requiring additional adjustments.

A tranched preferred investment is a transaction in which an investor agrees to buy a certain number of shares at an initial closing date, and additional shares at one or more future dates, at a pre-negotiated price regardless of whether the company’s value has changed for other reasons.

Typically, the future investments are contingent upon the company reaching certain milestones, and the two parties usually are committed to completing the subsequent tranches when the milestones are met. The tranched structure creates a contingent forward contract, rather than an option. Thus, if the price is pre-negotiated and the company’s value has changed as the milestones are reached, the purchase price is not indicative of Fair Value. To remedy this, tranched preferred financing transactions must be segmented between the initial investment and forward contracts, and valued separately.

To represent Fair Value, a transaction must be thoroughly vetted and at arm’s length whether or not the relationship is strategic and whether the investor is new or pre-existing. Applying the back-solve method to preferred stock transactions can be an effective means of calculating the Fair Value of a company so long as the aforementioned criteria are met, and more importantly, reasonable judgment is applied.

As a core competency and complement to our M&A practice, The McLean Valuation Services Group provides business valuation services, including intangible asset and financial security valuations for a variety of transaction, financial reporting, and tax purposes. The McLean Valuation Services Group has the requisite experience and credentials to support litigation proceedings, including quantifying economic damages and valuing business interests. Visit www.mcleanllc.com